ShowMeYour
Options!
BooksbySteve
Burns
How I Made
Money Using the
Nicolas Darvas
System
NewTrader,Rich
Trader
HowtoGetMore
Followers
on
Twitter
ShowMe
Your
Options!
TheGuideto
Complete
Confidencefor
EveryStockand
OptionsTrader
Seeking
Consistent,
Predictable
Returns
SteveBurns
Christopher
Ebert
Allrightsreserved.
Nopartofthispublicationmaybe
reproduced,storedinaretrieval
system,ortransmitted
inanyformorbyanymeans,
electronic,mechanical,
photocopyingorotherwise,without
thepriorpermissionof
thecopyrightowner.
ISBN:9781607964193
©Copyright2012bySteveBurnsand
ChristopherEbert
PublishedbyBNPublishing.
ALLRIGHTSRESERVED
[email protected]
www.bnpublishing.com
We wrote this
book to give
stock traders a
stockoptionbook
that was neither
so simple that it
insulted
their
intelligencebutat
thesametimenot
so complicated
thatitwasbeyond
comprehension.
We also wanted
to make it a fun
read as opposed
to feeling like a
boring
college
lecture.
We
believe we have
accomplished
thesemissions.
op·tion
[op-shuhn]
–noun
1.thepowerorrightof
choosing
2. something that may
beorischosen;choice
3.theactofchoosing
4.stockoption
5. a privilege acquired, as
by the payment of a
premium
or
consideration,
of
demanding, within a
specified time, the
carrying out of a
transaction
upon
stipulated terms; the
right, as granted in a
contract or by an
initial payment, of
acquiringsomethingin
thefuture
-Dictionary.com
CONTENTS
Foreword
Chapter 1 options are not
assets,theyarebets.
Chapter 2 every option
contract has a buyer and a
seller; one is long, one is
short, but which one has the
bestoddsofwinning?
Chapter 3 strong trends are
the friend of an option buyer
and the enemy of an option
seller.
Chapter 4 time is an option
seller’s friend, but the option
buyer’senemy.(theta)
Chapter 5 volatility is the
option buyer’s friend but the
optionseller’senemy.(vega)
Chapter 6 how much of the
move do you get for the
money?(delta)
Chapter 7 stocks for rent:
coveredcalls
Chapter 8 selling lottery
tickets:nakedoptions
Chapter 9 buying lottery
tickets: deep out-of-themoneyoptions
Chapter10 trends determine
who wins: strangles and
straddles
Chapter 11 the twins: every
position has a synthetic
relative
Chapter 12 spreads: ratio,
calendar,diagonal
Chapter13thewindbeneath
the pro’s wings: butterflies
andcondors
Chapter 14 dealing with the
behavioral problems of
immatureoptions
Chapter 15 A trader’s
choices: insurance, stop
losses,orruin
Chapter 16 your method,
yourrules,youredge
Appendix A: relative time
valueofoptionsbasedonthe
time to expiration of the
contract
Appendix B: odds and
expected payout of selected
optionstrategies
AppendixC:therelationship
between option premiums,
deltas, standard deviations,
andprofitprobabilities
Appendix
D:
time
progressionpayoutpotential
AppendixE:expandedtable
ofsyntheticpositions
AbouttheAuthors
Foreword
FOREWORD
Steve Burns and I met by chance,
however it was inevitable that we
would bump into each other given our
similartradingstylesandhowactivewe
are on Twitter in our niche. I was
lookingforsomeonetocontributebook
reviews on my blog and I discovered
that Steve had reviewed a mind
boggling amount of books with honest
andconcisesummaries.Consideringthe
knowledge that he has accumulated
from all those books that he read, I
believehimtobetheperfectcandidate
to share his knowledge with aspiring
traderstohelpthemavoidmanyofthe
pitfalls that new traders can run into. I
approachedStevetoseeifhewantedto
post his reviews on my site and soon
after we formed a strong relationship.
Steve's ability to sift through the sheer
amount of information available in
myriadbooksontradingandtakeaway
the important aspects traders need to
focusontobesuccessfulisremarkable
indeed.
Through Steve I was fortunate enough
to be introduced to the "Options
Scientist" Christopher Ebert. Steve
mentioned that Christopher had a firm
understanding of options and was very
creative with his option strategies, but
thatisanunderstatementasIwouldsay
heisinthetop1%ofunderstandingthe
insandoutsofoptionsasyouwillsoon
discover as you progress through
"Show Me Your Options." Working
with Chris as the resident options guru
on zentrader.ca has given me a chance
to learn from one of the best. Chris is
very generous with his time and is
alwayswillingtoansweranyquestions
I may have and offer suggestions on
howtostructureanoptiontrade.
This book has forced me to look at
optionsinawholenewlightasitdives
from the basics into extremely
advanced strategies in an easy to read
format. It could have more
appropriately been named, "Everything
you've ever wanted to know about
options, but didn't know to ask." They
coverstrategiesthatIdidn'tevenknow
existed.Havingbeentradingsince1998
I'll be the first to admit that I'm
intimidated by complex option
strategies,butthatcomesfromalackof
understanding. We fear what we don't
know.Thisbookmayrequireasecond
reading for option novices like myself,
but I highlighted many passages to
revisit and for the most part Chris and
Stevepresentthisinformationinastory
format from the standpoint of a
mentor/student that is very relatable.
Once armed with the new information
such as how to use straddles and
strangleseffectively,Icanexpandhow
I personally trade and invest through
theuseofoptions.
There are two kinds of traders in this
world.Thosewhouseoptionsandthose
whodon't.IbelieveSteveandChrisare
effectively bridging the gap. Being
primarily a momentum trader, I was a
littlesurprisedtoseetheauthor'sviews
oncoveredcalls,butitmakescomplete
senseafterreadingtheirlogic.
TheproblemwithCoveredCallwriting
is that you get a small premium to
relinquish the upside profit on a stock,
butyouretainthewholedownsiderisk.
Itislikedoingtheoppositeofwhatyou
want to do in trading; you are letting
your losers run and cutting your
winnersshort.
From this standpoint you should never
sell calls in a strong trend as you are
capping your winnings, or as they
describe more appropriately, a "stop
win", which flies in the face of what a
lotofoptionexpertswilltellyoutodo
with stocks in your portfolio. "Strong
trendsarethefriendofanoptionbuyer
andtheenemyofanoptionseller,"The
book is an education that you will
definitelygetyourmoneyoutof,ifyou
apply their principles and various
strategies.
When I was approached about writing
thisforwardIwashonouredandexcited
because I believe this is the book that
could help me wrap my head around
optionsandhelpboostmyequitycurve.
Iwastheirtargetmarket.Someonewho
has always wanted to implement
optionsintheirtradingbuthasn'tfound
a book that discusses the many
strategies without losing me in the
process-untilnow.Optionstalkcanbe
very technical but "Show Me Your
Options" is broken down into bite-size
chapters and useful options analogies
that will help anybody muddle through
options trading and come out on the
other side with a couple of strategies
theycanuserightnow.Themeasureof
a great trading book is whether I can
take what I read last week and inject
that into my trading on the next.
Missionaccomplishedguys.
JeffPierce
@zentrader
zentrader.ca
Chapter1
OPTIONSARE
NOTASSETS,
THEYARE
BETS.
Stock Trader heard
the alarm go off. He rolled
over in bed and hit his
belovedsnoozebutton.Itwas
time to head off to his day
job, but his mind rarely
stopped thinking of his
second job of trading.
Trading would be his ticket
out of the nine-to-five
corporate world. He wanted
to move from being an
employeeofacompanytoan
investor in the company. He
wantedhismoneytoworkfor
him and be able to stop
working for money. His
dream
was
financial
independence. Of course, all
hisfellowemployeesthought
he was nuts. Most of his
friends at work could not
comprehend ever not having
ajob,orthatnothavingajob
should even be a goal. Stock
Trader,though,wasdifferent;
he ignored all the negativity
and doubt and just kept on
doing what others believed
wasimpossible.
He beat the S&P 500
yearafteryear
He went to cash and
avoideddowntrends
He sold stocks short
and made money in
downtrends
Manymonthshemade
more trading than
working
He built his accounts
over time even during
marketcrashes
As he lay in bed he
realized why he continued
working so hard at trading.
Hewantedthefreedomtodo
what he wanted, when he
wanted. His goal was not
material
things,
oddly
enough. He wanted time, he
wanted freedom, and he did
not want to be a slave to
earning a wage and paying
bills.
“Isn’tthatgambling?”
They would ask him in a
concerned
and
slightly
condescendingtoneatwork.
“No, it is a business
likeanyother.Iusethesame
principles as any other
business. I buy and sell
inventory,Ifollowtrendsand
Imanagerisk.Iparticipatein
auctions and use best
practices to get an edge over
my
competitors.
The
company we work for
gambles more than I do,”
Stock Trader would respond.
Unfortunately, his audience
really didn’t understand what
hewastalkingabout.
With only a few
likeminded friends, Stock
Trader continued along his
journey in the stock market,
trading,reading,andlearning.
He truly loved the stock
market. He would watch
CNBC like other men
watched ESPN. While other
men were entering fantasy
baseballandfootballleagues,
hewasenteringstocktrading
contests online. For him it
was not just about making
money; it was a passion of
his, a challenge of both
strategy
and
wit.
Determinationandwillpower
separatedmanywinnersfrom
thelosersinthestockmarket.
He loved the stock market
game.
He had always loved
stock trading. He had been
fascinated with quotes and
what made stocks move up
and down from the time he
wasasmallchild.Asamatter
offact,hehadanaccountand
was trading something for as
long as he was legally old
enough to do so. When he
was too young for stocks, he
had collected and traded
coins, baseball cards, and
comic books. He did not
knowitatthetime,butthese
activities were training him
forthemarkets.
When
a
certain
superhero was popular, that
character’s comic books
would go up in value. A
movie release, cartoon, or
televisionshowcouldcausea
bullmarketinthatsuperhero.
Thispreparedhimtoseethat
a hot product could send a
company'sstocksoaring.
Future record setting
expectations for a rookie
baseball star set his cards on
an uptrend as long as he met
expectations for home runs,
batting average, and RBIs
each season, much like
earnings expectations drove
stock prices in the market.
One bad season could lower
thevalueoftheplayer’scards
just like a bad earnings
announcement could lower a
stock’s price. Rookie cards
couldmakebigmoneyiftheir
careers took off, just like
small cap companies in the
stockmarketiftheirproducts
and earnings took off in an
uptrend. Hall of Fame
players' cards stayed about
the same, their growth years
beingbehindthem.Everyone
knew where the Hall of
Famers would end up, much
like most big cap stocks that
just meander along at about
the same price with their
growth years being behind
them.
When he was young,
he visited coin shows and
made purchases for his
growing collection. Years
later, as he sold his coin
collection, he learned the
difference between what
something was purported to
beworthbyabookonprices
versus what a buyer was
willing to pay for it. There
was evidently a difference in
the price of the coins
depending on whether he
rented a booth and bought
coins from people trying to
sell them, or if he went to a
coin show and bought coins
as a customer. This taught
him about the bid/ask spread
in the market even before he
had traded a stock. There are
wholesale buyers and retail
sellersinmostindustries;the
stock market was no
different.
With an energy drink
in hand, he sat down and
pulleduphisaccounts,aswas
his daily ritual. He had two
different accounts: one tax
deferred for “retirement” and
a brokerage account. He
stared at the numbers:
$201,617 in his retirement
account and $103,725 in his
brokerageaccount.Ittook15
years of trading and some
luck to build his accounts to
this size. Many who knew
about his success thought he
was just lucky and had no
idea about the long hours he
spentstudyingthemarketsto
achieve his success. Unlike
his peers at work, he had
sidestepped the last bear
market that mauled many of
the buy-and-holders. He was
33 years old and had played
to win. He had used trend
trading and some swing
trading to achieve some
outstanding results. He
workedveryhardtobeinthe
right place at the right time
andtoseizetheopportunities
thelastbullmarketgavehim.
He also used the lessons of
past bear markets, which
mauledhim,toknowwhento
getoutandsellshort.Moving
averages,
support
and
resistance on the charts,
prices, and volume were his
constantfriendsandadvisors.
He had felt ready to
trade for a living on many
occasions. The dilemma he
faced was that he wanted to
produce a consistent income
from his capital while
exposing it to minimal risk.
He was at a place in his
trading career that he had to
takewhatheconsideredtobe
very large position sizes to
keep getting outperforming
returns. All he really needed
wasa15%-20%annualreturn
and he was financially free.
While he had accomplished
that many times, and even
many years in a row, the
problemwasthatreturnslike
that year after year would be
world class. Even the
fraudulent money manager,
Bernie Madoff, did not
produce consistent returns
which
matched
Stock
Trader’sgoals.
StockTraderneededa
way to trade with less risk
and yet produce a relatively
safe, regular income. His
trend trading, while it had
runsofhugereturns,alsohad
draw downs of capital. He
hated draw downs; the
method of trend trading he
used had losing years,
especially in very rangeboundandchoppymarkets.
So that day at work, Stock
Trader kept thinking through
his options: “High yield junk
bonds? If they were
diversified enough and if I
bought them on a pullback I
might be able to get 8% a
year in interest. That is not
enough.
Real
estate
investment
trusts
pay
dividends but not enough for
metomeetmyneeds.”
“Could I swing trade
for
consistent
returns?
Probably,untilatrendcaused
adrawdown,”thoughtStock
Trader.
“I really want the
oddsconsistentlyinmyfavor
ifthatwillbemysolesource
ofincome.”
That night, as Stock
Trader was doing his normal
Internet
surfing,
after
checking market quotes and
e-mailandsendingoutafew
tweets, he noticed a post in
hisFacebookgroup“Winning
Traders.”Itwasfromanew
member with the user name
Optionz Traderz. Stock
Trader did not like it when
people did not use their real
names on Facebook. He
thought that they needed to
go to Twitter or MySpace if
they were going to have
avatars and screen names.
Facebookwasforrealpeople.
Helookedatthepost.
Optionz Traderz: Who else
onherehashadsuccesslikeI
have had trading the triple
leveragedETFoptions?
No comments were
posted.
“Thispersonlovesthe
letter ‘Z’ and has a pink
Cadillacforaprofilepicture.
Nowheistalkingabouttriple
leveragedETFoptions?Heis
a different breed,” thought
StockTrader.
He waited, still no
comments.
Stock Trader felt the
needtofillthevoid.
StockTrader:Imostlytrade
stocks, not options. I believe
options are too risky. Using
triple leveraged ETF options
sounds like options on
steroids;theyaretoorichfor
myblood.
He received a posted
responseonFacebook.
Optionz Traderz: I believe
theyrepresenttheopportunity
ofalifetime;theycanbeused
to manage risk while giving
you amounts of leverage that
have only been available to
professionalsinthepast.
Stock Trader: You can also
loseatthefastestpaceever.
Optionz Traderz: The same
trading rules apply to 3x
options as to the rest of the
market.Thedifferenceisthat
youcangetthefullupsideof
atripleleveragedtrendwhile
the downside is controlled
with only the price you pay
for the option being at risk.
They are tools to increase
leverage and limit downside
risk. You can win big and
lose small with these. In the
past,theonlywaytoachieve
similar returns was to either
open a large number of
contracts or tie up a big
chunk of capital by
purchasing
the
shares
outright. Utilizing triple
leveraged ETFs cuts down
significantly on commissions
andfeeswhentradingoptions
and enables a huge reduction
in the amount of money at
risk when trading the
underlyingshares.
StockTrader:Ihavealways
thought of options as lottery
tickets.
Optionz Traderz: They are.
The good news is that the
odds of winning are on the
back of each lottery ticket,
and I have been working on
determiningtheoddsforeach
optionstrategy.Iftheoddsof
each strategy are known in
advance, it makes it easy to
sort out the good strategies
from the bad. However,
unlikelotterytickets,youcan
tilt the odds in your favor
with a good trading
methodology, just like in
stocks.
StockTrader:Iwanttoown
anasset,notalotteryticket.I
have not heard of very many
optiontradingsuccessstories.
Generally,Ithinktheyattract
under-funded rookies who
buy far out-of-the-money
options that the professionals
gladly sell to them to collect
premiums.
OptionzTraderz:Ifthepros
make that kind of easy
money, why don’t you sell
deep out-of-the-money 3x
optionsandreallycleanup?
Pause.
The wheels in Stock
Trader'sheadstartedturning.
“Whydidn’the?”Hethought
about it. “Would it be worth
it?Howmuchpremiumcould
he get from two or three
strike-out options? Didn’t
professionals love the Iron
Condor,orwhateverthatwas
called? Would this create
cash flow that he needed?
What would be the risk of a
Black Monday or market
crash?”
Stock Trader saw a
new member had just joined
the Winning Traders group.
He glanced at the name,
Rookie Trader. He couldn’t
helpfeelslightlyannoyedthat
someone who thought of
themselvesasarookiewould
join a group set up
specifically for experienced
traders. The thought quickly
passed when another post
appeared.
OptionzTraderz:DidIlose
you?
Stock Trader: No, you
actuallyperkedmyinterest.
Optionz Traderz: The 3x
options do have some
advantages over traditional
options and some even have
weekly options that trade.
They also have very good
volume for near months and
close-to-the-money options.
They are popular and for
goodreason.TheThetadecay
on 3x options is very
generous, although the
increased rate of decay
presents an additional risk
thatneedstobemanaged.
Stock Trader: I did some
trend trading with the triple
leveraged ETFs, so I am
familiarwiththem.
Optionz Traderz: The same
principles of successful stock
trading apply to option
trading, risk management,
psychology; and you need a
trading a method that gives
you an advantage through
better probabilities. The
differences are that for triple
leveraged options the option
seller gets a much larger
Theta premium, so if an Iron
Condor works for regular
options it can be even more
profitablefor3xoptions.The
optionbuyergetstheleverage
ofa3xETFwithaminimum
investment compared to the
dollar amount controlled. He
canbuyin-the-moneyoptions
andgetthefullmovementof
a trend and at the same time
have his daily returns
compound when he is right
and a trend continues for the
length of his option contract.
Also, a trader can go either
long or short in the market
with the same effort and get
the compounding on the way
down in a bear market. They
are powerful derivatives of
derivatives. They are like
derivatives 2.0 or derivatives
squared. I believe they give
good traders the opportunity
to make a lot of money with
limitedrisk.
Stock Trader: How long
haveyoutradedoptions?
Optionz
years.
Traderz:
Nine
StockTrader:Howhaveyou
done?
Optionz Traderz: I lost my
entire account the first year,
broke even the second year,
and have not had a losing
yearsince.
Stock Trader: Have you
made much money, Optionz
Traderz?
Optionz Traderz: I bought
my condo and my Cadillac
withcash.
Stock Trader: That is your
real car on your profile
picture?
OptionzTraderz: Yes, what
didyouthink,itwasadream
car?
Stock Trader: You never
know on social media who
youarechattingwith.
Optionz Traderz: I thought
itwouldbefuntotalktrading
online with like-minded
traders.
StockTrader:Itis.Gladyou
are in the group. We mainly
talk stocks and market
directioninthisgroup.
Optionz Traderz: I have
traded winning strategies
where it didn’t matter which
directionthemarketwentin.
Stock Trader: O.K., now
youhavelostme.Howisthat
possible?
OptionzTraderz:Youknow
the old Iron Condor – sell
optionsout-of-the-moneyand
buy options further out-ofthe-money. As long as the
trend doesn’t reach the long
options and they expire
worthless,
you
win,
regardless of the trend’s
direction; you are just
predicting the lack of the
trend’smagnitude.Thekeyis
to manage the risk of the
positiontheoneortwotimes
outoftenthattheunderlying
actually reaches the strike of
the long options. In options
you can buy a hedge or buy
back the option instead of
using stop losses. Options on
3x ETFs can also be used to
createalloftheotheroptions
combinations available on
non-leveraged funds. One of
my favorites, the Reverse
Iron Butterfly, can make a
nice profit when the
underlyingmovesupordown
by as little as one dollar,
sometimes less. Think about
it: would you rather have a
Reverse Iron Butterfly using
3xoptionsor1x?Sometimes
the cost to open both
Butterflies is similar, but the
triple leveraged Butterfly has
three times the odds of
success.
Stock Trader: Hmm… I
havenevertradedlikethat.
Optionz Traderz: I have; it
is sweet when you win eight
timesinarow.
Stock Trader: There are
optionsystemswith80%win
rates?
Optionz Traderz: Yes, but
the key is managing the two
lossescorrectlysoyoudonot
give back your profits from
the eight wins. The option
marketisveryefficient.Over
time, given a large enough
number of trades, all options
strategies tend to break even.
Theoddsarethathistorically
a system with 8 wins and 2
losses will take back all the
winning dollars with those
two losses. The key is to
manage those losses through
hedging or unwinding the
position. Each option system
has an inverse system, just
like there are long and short
stockstrategies,bullandbear
ETFs, and more recently, 3x
and inverse 3x ETFs. Option
systems
have
mirror
opposites. If you lost the 8
times in a row on the out-ofthe-money options that you
were long, the odds are you
wouldmakeitbackonthe9th
and 10th trades. This is
simplifying but you get the
idea.
Stock Trader: No Holy
Grail,justriskmanagement.
Optionz Traderz: Risk
management, discipline, and
a thoroughly tested trading
systemaretheHolyGrails.
Stock Trader: Well, I agree
with that; it is the same with
stocktrading.
Thenapostcameinfroma
newmemberofthegroup.
Rookie Trader: Good grief!
Youtwogetaroom.
Stock Trader: Very funny.
Well, it was great chatting
withyou.Iamgoingtosleep
on what you have said. Very
interesting.
Optionz Traderz: I look
forward to chatting again
sometime.
A little while later
therewasapostfromthenew
member. Stock Trader had
already shut down his
computer so he was not
awareofthediscussion.
Rookie Trader: Seriously,
you two are made for each
other. You make options
sound so complicated. You
use terms like long and short
and Condors and leverage. I
just got some stock options
from my employer and they
told me it was easy to make
moneyonthemandtherewas
norisk.
Optionz Traderz: The
optionsthatStockTraderand
I were discussing are
different from the ones you
are talking about. It is
confusing to a lot of people.
The options you own are
perks offered by employers
called Employer Stock
Options. They give you the
right to buy your company’s
stock at a specified price
sometime in the future. You
can make money on
Employer Stock Options
whenthestockpricegoesup.
The options we were
discussing are Standardized
Options that are traded on
major market exchanges,
similar to the way stocks are
traded on Wall Street and
otherstockexchangesaround
the world. Unlike Employer
Stock Options that are only
available to a select group of
employees,
Standardized
Options are available to
almost anyone who opens a
tradingaccount.
Rookie Trader: I saw what
you wrote about making
money no matter what
happens in the stock market.
Thatsoundslikesomekindof
scam.
Optionz Traderz: I can
assureyouitisnotascam.It
isaprovenmethodoftrading
that consistently produces
moreprofitsthanlosses.
RookieTrader:Ifthat’strue,
whyisn’teverybodydoingit?
Optionz Traderz: A lot of
people are doing it. But it
involves risks, just like any
other investment. Some
investors are not comfortable
withtherisks.Otherinvestors
do not take the time to learn
the risks and end up losing a
lotofmoney.
Rookie Trader: You said
you made enough money to
buy an expensive car and a
condominium.
Optionz Traderz: It is
possible. However, it is not
easy money. If you want to
profit from trading options,
you will need to understand
howtheybehave.
RookieTrader:IfIcantrade
options and make enough
money to buy a car and a
condo, then I want to know
how options work. How do I
getstarted?
OptionzTraderz:Thereare
many books about options.
You can find a huge amount
of information on the
Internet. Also, you might
want to watch videos, take
classes, or attend seminars
dedicatedtoexplainingallof
thedifferentoptionstrategies.
Rookie Trader: Is it really
thatsimple?
Optionz Traderz: I
wouldn’tcallitsimple.Ifyou
want to trade options and
make consistent profits, you
will need to dedicate some
time to learning about them.
Youwillalsoneedtopractice
trading.Itisnodifferentthan
learning how to do any job.
To be good at anything, you
needtolearnandyouneedto
practice.
RookieTrader:Practice?
OptionzTraderz:Yes,after
youhavestudiedoptionsand
all of the strategies, you will
need to design a trading
systemthatfitsyourpersonal
taste. Then you will need to
practice trading your system
untilyouaregoodatit.There
are several ways you can
practice. A very simple way
istoopenahypotheticaltrade
and use historical prices to
see how it would have
performed in the past. Next,
you might want to try
opening a fictional trade to
see how it performs in real
time. There are many
websites that offer virtual
trading for free. When you
are satisfied with the results,
you can continue practicing
byopeningasmalltradewith
real money. When you have
practiced enough, you will
have the confidence to trade
options in real time with real
money.
Rookie Trader: I am glad I
joined this group. You have
givenmesomerealhopethat
I can be as wealthy as you. I
can’twaittogetstarted.
Optionz Traderz: Good to
hear it. It has been nice
talking to you, but I really
needtogetsomesleepnow.
The next evening,
Stock Trader was sitting at
his computer with his usual
energydrink.Hecheckedhis
accounts: $201,675 in his
retirement account and
$103,599 in his brokerage
account. After seeing that
markets were mostly flat
worldwide, he tuned into
CNBC for a while. He
watched for a few minutes,
but the report about a global
surplus of bananas did not
keep his attention for very
long.
Soon he was cleaning
up his e-mail and looking at
his Facebook page. Once
there, he saw that there were
additional comments in the
Winning Traders group he
had visited the previous day.
He read through the
comments between Optionz
Traderz and Rookie Trader.
“Why is this guy, with all of
his experience, taking the
time to discuss options with
someone so inexperienced?”
he thought. Then his eyes
were drawn to the pink
Cadillac icon in the
“members online” section of
thepage.
That pink Cadillac
stuck in his mind. As
successful as he was at
tradingstocks,hehadnotyet
found a trading system that
could justify selling his old
pickup truck and buying his
dream car. Stock Trader had
thought
about
his
conversation with Optionz
Traderz all day while he was
at work. Was it really
possibletomakemoneywith
options no matter what the
marketwasdoing?Couldthis
be his ticket to having the
lifestyle he wanted so much?
So many questions filled his
mind that there was nothing
else he could think about.
Now was his chance to get
some answers. He began
typing.
Stock Trader: What do you
think about that Rookie
Trader? How long do you
estimate it will take him to
loseeverything?Igivehim2
months,tops.
Therewasapausefor
afewminutes.
“Maybemycomment
was offensive,” Stock Trader
thought. But his fears were
allayed when after a few
minutestherewasanewpost.
Optionz Traderz: I always
liketohelppeoplewhowant
to learn about options. After
losing everything in my first
year of trading, I feel like I
am helping others avoid the
samemistakesthatImade.
StockTrader:Alldaywhile
IwasatworkIcouldn’tstop
thinking about what you said
about making money no
matter what the market does.
I would really like to learn
how you do it. As successful
asIhavebeenatbuildingmy
retirement funds and my
brokerage account, a method
of investing that generates
consistent income is what I
am seeking the most at this
pointinmylife.Ifoptionsare
the answer, I hope you will
shareyourtradingsecrets.
Optionz Traderz: I enjoy
sharing.It’srefreshingtofind
peoplewiththatsameinterest
in options. Sometimes I talk
aboutoptionswithmyfriends
andIgetnothingbutablank
stare, as if I were the most
boringpersononEarth.
Stock Trader: I don’t find
options boring at all. To me,
they seem like the most
exciting trading tools I have
everencountered.
Just as Stock Trader
was beginning to enjoy the
conversation,
it
was
interrupted by a new post
fromthebeginner.
Rookie Trader: I thought it
wasgoingtobeeasytolearn
options,butwhenIlookedup
someinformationaboutthem,
all I found was a bunch of
complicated equations. How
can you two possibly get
excited over some stupid
equations?
Optionz
Traderz:
I
understand your frustration
with the formulas. I studied
calculus in college, and even
with
my
mathematical
background the differential
equations that are used to
determine options pricing are
difficultformetounderstand.
Frommyexperience,itisnot
necessary to understand the
formulas to make a profit.
Thereisplentyofinformation
available on options that can
easily be understood without
a mathematics degree. I
suggest you keep looking
until you find a book that
explains options in a manner
thatmakessensetoyou.
Stock Trader: I have to
admit I was a little
intimidated when I started
trading options and saw the
Black-Scholes model and all
of its equations. When I
encountered terms like
Implied Volatility and “the
Greeks,” I thought I might
have been in over my head.
But I stuck with it and am
gladIdid.
Optionz Traderz: BlackScholes is merely an
explanation of how the
market
determines
the
premiums for options. I
believe it is important to
understand why the formulas
exist. Implied volatility and
the Greeks are helpful as
well, but understanding them
does not necessarily increase
a
trader’s
profitability.
Profiting from options is not
about formulas; it is about
developing a trading system
thatworksintherealworld.
Stock Trader: I agree with
you there. If profiting from
optionswasonlyavailableto
those who understood the
formulas, we would live in a
world where the option
scientistscontrolledallofthe
wealth.
Optionz Traderz: I don’t
knowwhetherornotIshould
be insulted by that comment,
as I see myself as a sort of
optionscientist.
StockTrader:Ididnotmean
to insult you. I really would
liketoseemoreofyourideas
onhowtoprofitregardlessof
what the stock market is
doing.
Then
another
interruption came from the
novicetrader.
Rookie Trader: Hey, you
two, I saw you talking about
the Holy Grail earlier. I just
bought a subscription to a
websitethatsaysithasfound
the Holy Grail. All I need to
doissellCoveredCallsandI
am guaranteed thousands of
dollars of income every
month. What do you think?
Not bad for a 22-year-old
who doesn’t understand
formulas,huh?
Optionz Traderz: Yes, it is
possible to generate income
with Covered Calls. But you
need to understand the risks
before you start trading. I
really hope you test it for a
whilebeforeyoustarttrading
with real money. Writing
CoveredCallscouldlooklike
theHolyGrailinaflatorup
trendingmarketandyoumay
evengetbyinamarketthatis
slightly trending down,
reselling Calls on the way
down. The problem is that in
a sharp market downtrend or
a crash you will take the full
losses while only receiving a
small premium and will not
beabletoregainthelossesin
an uptrend because the Call
holderwillgetthefullupside.
I would like to discuss this
moretomorrow.
Stock Trader: It is hard to
believe that I, too, was that
naïve at one point. I guess
everybody has the same
reaction when they are
exposed to options for the
firsttime.Insomewaysthey
look so simple to trade; in
other ways they seem too
complicated to understand.
Andtherearesomanysharks
in the water just waiting to
prey on the next trader’s
inexperience.
Optionz Traderz: You
nailed it! That was my
experience, exactly. I am
lookingforwardtotellingyou
howIwasabletoprofitfrom
options; unfortunately I have
a service appointment at the
Cadillac dealer early in the
morning.IfIdon’tgettobed
soon, I might oversleep. I’ll
be here again later tomorrow
morning though. I can tell
youmorethen.
Stock Trader: O.K.,
tomorrowmorningitis.
Chapter2
EVERY
OPTION
CONTRACT
HASABUYER
ANDA
SELLER;ONE
ISLONG,ONE
ISSHORT,BUT
WHICHONE
HASTHEBEST
ODDSOF
WINNING?
Stock Trader opened
his eyes. “No alarm?” he
thought. Oh, it was a blissful
day off – no job and no
responsibilities. He could get
up when he chose and do
what he wanted. He wished
every day could be like
Saturday; maybe one day
they would be. He almost
slippedintoamilddepression
on some Saturdays when
there was no market to
follow. He enjoyed key parts
ofeverytradingdaywhenthe
stockmarketwasopen.When
heawokeontradingdays,he
was curious how the Asian
markets closed; next he
would look at what levels
European markets were
trading; and then he had to
see the action in the premarket in the United States
and of course the futures.
Afterhehadhisenergydrink
andlookedattheupdates,he
would move on to his day
job. However he made sure
thathecheckedintoseehow
themarketopenedandwhere
itwasbeforelunchtime.Then
he liked seeing where the
market was two hours before
the close. Finally, at the end
of the day, he studied the
closingpricesonalong-term
chartandexaminedtheday’s
volume.
His watch lists were
generally composed of the
major indexes: the S&P 500,
the Dow Jones Industrial
Average,andtheNasdaq.He
wouldwatchthesealongwith
aboutfivestocksonwhichhe
was bullish. By watching
these fluctuations over the
years he got a feel for the
markets. He used his
observationstobuildsystems
that he used in his trading.
Thesesystemsweredesigned
basedonwhatthemarkethad
done in the past. They were
mainly built on past price
action that he believed was
caused by other trader’s
emotions.Hethoughtalotof
the market behavior was
caused by emotions, and his
long-term charts helped him
predictthoseemotions.These
systemsworkedforhim.
He had moved away
from his discretionary shootfrom-the-hip trading. He no
longerbelievedhecouldbeat
themarketbybeingamarket
genius. He now believed that
by placing high probability
trades he would win in the
longrun.
His mind drifted back
to what Optionz Traderz had
postedintheonlinegroup.
“An 80% win rate?
Could options put the odds
thatmuchinmyfavor?What
weretherisks?”
With those kinds of
odds, he could pay bills
through his trading on a
regular basis. He had traded
systems that had given him
those kinds of winning
percentages, but in stocks
those results were more a
function of the market
environmentthanalong-term
sustainable
winning
percentage.Techstockswere
great for day traders in the
late 1990s, and then trend
traders cleaned up in the fall
of 2008 by shorting financial
stocks. However, when the
tech bubble burst in early
2000 and when the market
reversed and got choppy in
early 2009, those same
tradersrealizedtheywerenot
the geniuses they believed
themselves to be. He no
longer had any delusions
abouteasyover-performance;
he knew you earned your
keepinthemarkets.
He
wondered
if
options,withalltheirmoving
parts, were something he
could use for a steady
income. He really liked the
idea of selling the sucker
bets,thefarout-of-the-money
optionsthatamateurslovedto
buy. If they were going to
expire worthless eight times
andheonlyhadtocutlosses
earlytwice,thatwouldbehis
ticket. He had to look up
someoptiontablestoseehow
much he could get for them
and calculate his margin
requirements.
He
was
intrigued.
He went over to his
computer and signed on
although it was not his usual
routine for a Saturday. He
usuallyreadandrelaxedearly
inthemorningandsurfedthe
web at night. But he signed
onanywayandwenttohisemail.Hehadane-mailinhis
inbox from his Facebook
account; it was a friend
request
from
Optionz
Traderz. He already felt that
Optionz
Traderz
was
violating a Facebook rule
with the use of a misspelled
name. In his mind, this guy
was now violating a second
Facebook rule of his; he
wouldchatingroups,buthis
Facebook account was for
family and real friends only.
He did not know who the
heck Optionz Traderz really
was.Buttheresatthefamiliar
Cadillac on the message in
hisinbox.
“This guy is too
much,”saidStockTraderout
loud.
He clicked to accept
the friend request, but he
didn’t really know why he
wasdoingso.Theycouldjust
as easily chat online without
having to be Facebook
“friends.” He was doing
things he usually did not do;
it seemed Optionz Traderz
had a knack for easily
crossing Stock Trader’s
boundariesonthefirsttry.
In the late morning,
Stock Trader pulled up his
Facebookaccountandclicked
on his Winning Traders
group. Only a few of his
buddies were online. He
looked at some of the posts
from the previous evening.
Posted were the usual
prognosticationsofwherethe
market was going: which
stocks were hot and where
supportandresistancewasin
the major averages. There
were also a few annoying
penny stock pumpers that
wereconstantlypushingsome
garbage penny stock on the
over-the-counter market. He
readoneofseveralposts.
PennyTrader:ZXLLjusthit
.06cents,likewepredicted.
StockTrader:Whocares?
Penny Trader was
offline,probablyenjoyinghis
Saturday,sonoresponsewas
forthcoming. Stock Trader
feltalittleboredomcreeping
inwhenhesawthispost.
Rookie Trader: I have read
overtheinformationfrommy
Covered Call Holy Grail. I
havedoneit;Ifoundasystem
thatcannotlose.Iwillnotbe
able to make the thousands I
thought I would, though,
becauseIdonothaveenough
money to invest right now.
But I can make hundreds
easily!
Stock Trader: Are you
serious?
Rookie Trader: I have the
simulatedrecordstoproveit.
In back-testing, it worked
perfectly. You simply get a
great stock and sell threemonth-out Call options, over
and over again. Even if the
market trends down, you just
sell another option. You
generateincomeeverymonth
andkeepthestock.Ihavethe
proof in all the thorough
back-testing.
Optionz Traderz: I believe
whatyouareseeingiswhatis
called“curbfitting,”wherein
hindsight people create a
systemthatworks.Inthereal
world,inrealtime,thingsdo
not always work out
perfectly.
Rookie Trader: How can I
lose if I still own the stock
and sell Calls against it for
income? Looking at the Call
prices, I should collect
enough premiums to cover
the cost of the stock itself in
18monthsonsomeofthese.
OptionzTraderz:Oh,letme
count the ways. It will work
out fine if you have picked a
great stock and you are in a
bullmarket.Unfortunately,in
the real world, there are bear
markets, down trends, Black
Swan events, scandals, and
bankruptcies. If Covered
Calls were the golden ticket
into the Willie Wonka
factory, we would all quit
trading and go in and eat the
chocolate. If you found great
companies in a bull market
youcouldmakemoremoney
buying Calls in those hot
stocks,notsellingthem.
RookieTrader:Huh?
Stock Trader: Preach it,
brother!
Optionz Traderz: There is
no Holy Grail in trading.
There are probabilities, risk
management,
historically
winning systems, discipline,
and trends. But no system
winsallthetime.Lookingfor
a Holy Grail is a sign of not
understanding the market.
Many investors thought
selling
out-of-the-money
Naked Puts in the late
eighties was the Holy Grail,
andtheywonalmost100%of
the time until Black Monday
in 1987 bankrupted many of
them in a matter of a few
days.
Rookie Trader: But I have
theback-testsrighthere.
Optionz Traderz: I am sure
they hand-selected some
wonderful stocks like an
Apple or a Google, not an
Enron or a Global Crossing
duringanaccountingscandal.
Iamsuretheydidnotpickan
Exxon or a BP during an oil
spill. I bet they never would
have selected Internet stocks
inMarchof2000orfinancial
stocks in 2008. Any of these
choices would leave a huge
hole in your strategy, unless
you had strong stop loss
rules. A Black Monday or
market meltdown would
reallydevastateyourstrategy.
Rookie Trader: But it
explains how in the long run
itisawinningsystem.
Optionz Traderz: If you
select the right stocks it may
be. What does it say is your
averagedrawdown?
Rookie Trader: What is
that?
Optionz Traderz: How
much you can expect to lose
when the market moves
contrarytowhatisneededto
beprofitable.
Rookie Trader: It says it
alwayswins,everymonth.
Optionz Traderz: Now I
knowyouhavebeenconned;
all systems have losing
months and years. There is
onlyoneoptiontradethatcan
neverlose.Wouldyouliketo
knowwhatitis?
RookieTrader:Ifyouknow
of a trade that can’t lose, of
courseIwanttoknow.
Optionz Traderz: Pick any
stock, then sell a Covered
Call and buy a Put at the
samestrikeprice.
Therewasapausefor
afewminutes.
Rookie Trader: You are a
genius! This trade can never
lose.Nomatterhowmuchthe
stockdrops,IcanusethePut
to sell it without any loss. Is
thishowyoumadeallofyour
moneytobuyyourCadillac?
Optionz Traderz: No, I did
not. If you look closely, the
trade I described wins 100%
ofthetime,butthemaximum
profit is always zero. You
would probably even lose a
little on the bid-ask spread,
plus you would have
commissions to deal with.
There is no risk in this trade
and therefore there is no
reward. The reward of an
options trade is exactly
proportionaltotherisk.There
isnoHolyGrailwithoptions.
Stock Trader: If those guys
had the Holy Grail, they
would be managing big
money, not selling $100
black-box systems. Good
grief! Writing Covered Calls
is not rocket science; you
don’t need to buy a program
todoit.
Optionz Traderz: The
problem with Covered Call
writingisthatyougetasmall
premium to relinquish the
upside profit on a stock, but
you retain the whole
downsiderisk.Itislikedoing
theoppositeofwhatyouwant
to do in trading; you are
letting your losers run and
cuttingyourwinnersshort.A
friendofmineoncedescribed
a Covered Call as the exact
opposite of a stop loss. He
likes to refer to a Covered
Callasa“stopwin.”
Stock Trader: That sounds
like the worst thing you can
do.Itmakesmewonderwhy
theyaresowidelypromoted.
OptionzTraderz: It is often
touted as the safest way to
use options, but in reality it
canbealosingsysteminbear
markets. In raging bull
markets you give up the
uptrend and in bear markets
youreceiveallthelosses.The
efficiency of the options
marketandcommissioncosts
make it a poor bet most the
time.Withthatsaid,thereare
times, especially when
volatility is elevated, when it
makes sense to sell Covered
Calls.Othertimesitmightbe
safer to sell a Straddle or
Strangle.
StockTrader:Awhat?That
sounds violent. I guess I
always just accepted the
belief that the Covered Call
was one of the safest options
strategies.
Optionz Traderz: Selling a
CoveredCallisjustasystem
and one of many strategies.
They all have inverse bets,
and all work best in specific
market environments. If you
aretheCallbuyeryougetthe
fullupside,butarelimitedto
losingonlytheamountofthe
intrinsicvalueandtimevalue.
There are times you should
buy Calls and other times
when you should sell them.
From my years of options
research, it is evident that all
systems, left to run
unmanaged, revert back to
their mean and investors
break even. The only way to
outperform
is
through
managingtheinherentrisk.
Stock Traderz: I never
thoughtofitthatwaybefore.
Options systems are like
stock systems, and the way
you win is to manage the
risk?
Optionz Traderz: Yes. Risk
iswhatoptionsareallabout–
asellersellingtheirownrisk
for a price. The seller of a
Call option is renting a stock
tothebuyeroftheoptionfor
a set period of time, while
retaining all of the risk. The
buyer is paying the seller a
set amount of money for
control of the profits of the
underlyingstock,butwithout
the risks inherent to owning
thestock.
Stock Trader:
Selling
options sounds risky, but I
have had a lot of people tell
me that selling options is the
onlywaytomakeaprofit.
OptionzTraderz: Thanks to
the Black-Scholes model and
market
efficiency,
the
premiums usually reflect the
correctpriceofalltheknown
risksinvolvedatthetimethe
contract is opened. Selling is
no different than buying. All
you have to do is beat the
efficient
market
and
commissions and you will
make a profit. Are you
familiar with Matthew 13 in
theBible?
Stock Trader: I am familiar
with the Book of Matthew,
butIdon’thavethepassages
memorized. What does it
havetodowithoptions?
Optionz Traderz: That
passage is a perfect analogy
tooptions.Itreads:“Asower
wentforthtosow;Andwhen
hesowed,someseedsfellby
the wayside, and the fowls
came and devoured them up:
Some fell upon stony places,
where they had not much
earth: and forthwith they
sprung up, because they had
no deepness of earth: And
when the sun was up, they
were scorched; and because
they had no root, they
witheredaway.Andsomefell
amongthorns;andthethorns
sprung up, and choked them:
But others fell into good
ground, and brought forth
fruit, some a hundredfold,
some
sixtyfold,
some
thirtyfold.” Options are like
seeds. You want to get the
mostoutofeachone,soyou
needtochoosethebestplace
andtimetouseeachone.
Stock Trader: I see. So you
are saying that by just
opening options as if I were
randomly planting seeds,
market
forces
would
immediatelydevourthevalue
of some of them; others
would be in the wrong place
at the wrong time to make a
profit, and some would be in
the right place but would
have the value choked out of
them by whipsaw. The ones
thatremainedwouldmultiply
invalue.
Optionz Traderz: Blindly
tradingoptionsisthesameas
blindly sowing seeds. For
every winning buyer there is
a losing seller, and for every
winning seller there is a
losingbuyer.Unlikethestock
market, the options market
doesnotincreaseordecrease
thetotalamountofwealth;it
just shifts it around. The key
to making money with
options is managing the risk.
You will have much better
luck if you plant your seeds
ingoodground.
Stock Trader: How do you
dothatinoptions?
Optionz Traderz: The same
way you do in regular
trading: methodology and
discipline. The rules don’t
change, just the complexity.
Goingfromstockstooptions
islikegoingfromcheckersto
chess. Pieces start moving in
nine directions, not just four.
It seems much more
complicated, but the basics
are the same. You are trying
to
out-maneuver
your
opponentandgettheirpieces.
Stock Traderz: That is
another good analogy, but I
have always been told that
option sellers make more
money than option buyers.
That
always
sounded
believable to me because the
option buyer needs to have
theunderlyingstocknotonly
goin-the-money,butgodeep
enoughtocoverthepremium.
Don’tsellershavebetterodds
thanbuyers?
Optionz Traderz: Neither
one has better odds; all
options are created equal.
There are times that option
sellersmakemoneyandtimes
when option buyers do.
Market conditions determine
which side has the better
odds. On average, selling
options is no better than
buying. I have seen studies
that indicate that markets
movesidewaysabout75%of
thetimeandtrend25%ofthe
time. Even with 75-25 odds,
an option seller is no better
offthananoptionbuyer.The
seller’s winning profits,
whichinmyexperienceoccur
two-thirdsofthetime,willon
average be wiped out by the
losses that occur one-third of
the time. Likewise, buyers
will rarely make money, but
whentheydotheywillmake
alot.
I think the perception that
sellers make more money
stems from two aspects of
trading. First, sellers make
profits twice as often as
buyers; and second, many
sellers are market makers.
Market makers who sell
options do make consistent
profits, but not because
selling is more profitable;
their profits are the result of
their ability to sell options at
the higher ask price and buy
them at the lower bid price.
Thinkofthemaswholesalers,
making money on the price
markuptotheretailer.
Stock Trader: Now I
understand what you are
saying.Inabearmarket,Call
writers and Put buyers are
making money, and in a bull
market it is just the opposite.
In a more common sideways
market, all of the buyers are
losing their profits, and the
sellersaremakingupfortheir
previouslosses.
Optionz Traderz: Exactly!
Youcanbuyanylistedoption
for a price. It is up to you to
determine which side of the
bethasthebetterodds.Ifthe
market just experienced a
huge move and had also
becomevolatile,itmightbea
great time to sell far out-ofthe-money Call and Put
options to benefit from the
increase in premiums due to
volatility. If there were a
huge systemic risk in the
financialsector,itmightbea
good time to buy threemonth-out Puts that are atthe-money on the whole
sector. If you were to find a
stock that you thought was
thegreatestthingsincesliced
bread, rather than buy the
shares, you could buy in-themoneyCalls,getmuchbetter
leverage,andbeabletousea
smaller amount of capital
while also limiting your
downside risk. You can use
options just like you use
stocks; the key is to
understandhowtheyfunction
andtherisksinvolved.
Stock Trader: You are
actually
beginning
to
convince me that options
could be less risky than
stocks are. That is quite an
accomplishment.
Optionz Traderz: When
used correctly they can help
reduce risk substantially
while leaving the profit
potential in place. There are
many different ways to use
themforprofitsbecausethere
are many ways that they
work.Youjusthavetofinda
style
that
fits
your
personality, and above all,
define your maximum risk
andprofitgoalbeforeplacing
thetrade.
Stock Trader: I am very
interestedinlearningmore.
Rookie Trader: I could emailyouguystheHolyGrail
soyoudon’thavetothinkso
hard.
Stock Trader: Ugh! I am
going to run some errands
and look at some option
tables.
Optionz Traderz: I am
going to get a margarita and
sitbythepool.
Stock Trader was
feeling much better than
usualforaSaturdaymorning.
Even though there was little
financial news for him to
follow,hewasgrowingmore
confidentthattradingoptions
was going to be his key to
financial freedom. He was
impressedbytheexplanations
that Optionz Traderz had
given, although he had to
admit that he was a little
surprised to learn that every
optionsstrategyhasthesame
long-term
odds
of
profitability.
However,
knowing that one vital piece
ofinformationmadehimfeel
much better about options
than he had ever felt in the
past.Ifeveryoptionsstrategy
wascreatedequal,hedidnot
needtobesoconcernedabout
learning every strategy.
Instead, he needed to learn
how to best apply the
strategies that he did
understand.
Stock
Trader’s
success in the stock market
wasbasedononesimplerule:
Win more money than you
lose. Profiting as a stock
trader required only that he
take advantage of trends,
going long in up trends,
selling and selling short in
downtrends. Charts of price
and volume gave him all of
the information he needed to
spotatrend.OptionzTraderz
hadopenedhiseyestoanew
way of trading, one where
profits could be had in
sideways markets as well as
trends.“IfIwasabletomake
substantialprofitsinthestock
market simply by putting the
oddsinmyfavor,surelyIcan
do that even better with
options,”hethought.
Stock Trader’s mind
started
wandering.
He
thought about a time many
years earlier when his broker
had recommended a mutual
fund that had a historical
returnof8%peryear.Atthe
time, it seemed like a great
waytogetstartedinthestock
market–buyingadiversified
fund with a history of
profitability, managed by
professionals. But he could
notforgetthe5%salescharge
taken off the top, nor the
three years of losses that
followed. Looking at options
tables, he could not help but
notice that a lot of year-out
Put options had premiums
thatwerelessthan5%ofthe
underlying stock price. “If
only I had known this years
agoIwouldhavejustbought
stocks and protective Puts
instead of mutual funds,” he
thought. After all, the
premiums on the Puts were
aboutthesameastheloadon
a mutual fund. “Not only
would I have had the same
upside potential as a mutual
fund, but I would not have
suffered those three years of
losses.”
As he researched one
of the five stocks he was
following, he noticed that it
had just pushed through
resistance on high volume.
The ten day moving average
had also just crossed above
the twenty-day average. He
knew the emotions that
investors would feel with
such movements; outsiders
would be enticed to buy,
those who were short would
feel the need to cover their
shorts, and the buy-andholders would feel less
pressure to sell. In the past,
Stock Trader might have
chosen to buy the stock on
Monday morning, if it held
above resistance on good
volume. Instead, he found
himself looking at the option
tables to find the premiums
forin-the-moneyCalls.
It seemed Optionz
Traderz had affected his
entire outlook on trading.
“Here is a guy I have only
known for a few days, that I
have never met except
throughFacebook,andyethe
haschangedthewayItrade,”
he thought to himself. Stock
Traderhadnevermetanyone
with an understanding of
optionslikeOptionzTraderz.
He liked having someone
new to talk to about trading.
Itwasn’tthathedidnotenjoy
discussing the markets with
his longtime friends, but this
wassomeonewithsomefresh
ideas about a new way to
trade. Although they were
traders of two entirely
different instruments, he was
surprised at the similarity of
their trading philosophies.
But he could not help but to
thinkonething:“Amargarita,
really? You have to be
kidding me. What a girl’s
drink!”
Chapter3
STRONG
TRENDSARE
THEFRIEND
OFANOPTION
BUYERAND
THEENEMY
OFANOPTION
SELLER.
Stock Trader awoke
onSundaymorning,hismind
racing
through
option
strategies before he even got
outofbed.Hewaspondering
what his new friend had said
about all bets from both
buyersandsellersrevertingto
the mean over time. He
thought the same was
probablytrueinstocktrading.
Hehadheardmanyastoryof
a hot-shot hedge fund
manager, thinking he knew
the markets inside and out,
then proving his skills by
havingagreatyearmanaging
afund,returningmaybe40%
gains in an otherwise down
year for the broader market.
This guy got millions in
bonuses and was treated like
a rock star; money poured
intohisfund.Butthen,many
times the strangest thing
would happen; he would be
flat the next year and maybe
down10%thenextyear,and
to add insult to injury, down
30% the 4th year, eventually
giving back all his previous
gains. What had happened?
The zero-sum game and the
efficient market brought the
trader back to the mean
average. The ‘rock star’
trader simply traded the
correct way during one
particular
market
environment, but failed to
adapt when the environment
changed. He may have been
buying all the dips during a
bull market, but doing the
same in a future bear market
only resulted in a succession
of losses – losses that would
sometimes exceed the gains
he achieved in the preceding
bull market. Even the most
touted investment con in
history,
“buy-and-hold
investing,” brings many
investors back to even after
periods of ten years,
especiallywhentheeffectsof
inflation are taken into
account.Theresultofbuying
into these ‘rock star’
managed funds can be
devastating to a portfolio,
even in an average market,
andcripplingduringasevere
bearmarket.
Stock Trader had
made most of his money
trading trends. He thought
this style gave traders an
advantage over the majority
of market participants. Some
of history’s best traders did
not try to predict the future
pricesofstocks.Theysimply
reacted to the current price;
they looked for the trend.
They had different ways of
measuring trends. Some
lovedtobuybreakoutstonew
highs; others wanted to trade
trend reversals; many used
moving averages, and some
boughtastockorindexwhen
the highest price, over a set
number of days, had been
reached. Even though they
were trading using different
entries and exits, and
although some of them were
trading commodities and
currencies in addition to
stocks,theyallwereinsearch
ofthesamething:identifying
and trading trends. Stock
Traderwondered:“HowcanI
use options to trade trends
more safely and with more
leverage? What does an
optiontrendtraderlooklike?
What option strategies would
be best suited to trend
trading?” Stock Trader had
neverheardofanoptiontrend
trader before, but he was
confident that such people
mustsurelyexist.
Stock Trader also
combined risk management
into his trend trading. He
wouldlethiswinnersrunand
cut his losers short. He
wantedtolosesmallandwin
big. He had found that most
successful trend traders often
had many small losses
preceding their really big
wins.Mosttrendtraderswere
simply ‘betting’ that markets
and stocks would eventually
trend strongly in one
directionortheotheroverthe
long term. If their bet was
wrong they would take their
money off the table quickly,
usually only risking 1% to
3% of total capital. This
allowed them to be wrong
many
times
without
destroying their account.
When they were right, the
best trend traders allowed
their winning trades to run
with the trend, utilizing
systematicstopswhichwould
cause them to sell out on a
pull back, often to a moving
average or recent low price.
He and other trend traders
required only one thing: that
their big winning trades pay
for all their small losses and
give them an overall profit.
Stock Trader was thinking
throughalloftheseprinciples
andtryingtoconnectthemto
optiontrading.Howcouldhe
use options to control risk
while trend trading? How
could he use options to
capturetrendswithouthaving
to predict anything? It was
timetogettheanswerstraight
fromthesource.
Stock Trader looked
to see who was online in his
Facebookgroup.
He clicked on his
Winning Traders group and
opened the group’s box. He
sawthathewasjoinedby:
RookieTrader
PennyTrader
PennyPumper
GhostofDarvas
“Good Grief!” he
thought.
He felt a desire to
chatwithOptionzTraderz.
Penny Pumper: ZXLL is at
.06 and is projected to go to
$1.00; you need to get in
now!
RookieTrader:Canyousell
CoveredCallsonZXLL?
Stock
Trader:
Penny
Pumper: I will pay you a
dollartogetoutofthisgroup
and go pump the over-thecounter penny stock garbage
out of a boiler room. Rookie
Trader: Can you do math?
Howdoyouselloptionsoffa
$.06 stock? OTC stocks do
nothaveoptions;theydonot
even have much volume on
thesharesthemselvesmostof
the time. Good grief, guys,
really?
No response from
Rookie Trader or Penny
Pumper.
Optionz Traderz: Is this
group for winning traders or
justanyone?
Stock Trader: Anyone can
join.
Optionz
Obviously!
Traderz:
Stock Trader: Glad to see
you online. I have the option
questionoftheday.
Optionz Traderz: I hope I
havetheoptionanswerofthe
day.
Stock Trader: What is the
best way to use trend trading
methods with options? Say
you have indications that
thereisahighprobabilitythat
themarketorastockisabout
to trend in one direction
sharply;howdoyouplayit?
Optionz Traderz: That is a
goodone!Ifyouwerebullish
onastockoveralongperiod
of time, I would suggest you
play a slightly in-the-money
Long Call, two or three
months out. But you would
onlywanttodothisonstocks
that have options traded in a
sufficient volume to ensure
that the bid and ask spread
doesn’t eat up your profits
goinginandgoingout.Being
a relatively long-term play,
youwouldmostlikelydobest
by avoiding the current
month options because the
Theta decay is accelerated in
the final month of an option
contract.However,ifyoufelt
more comfortable using the
current month options, you
couldloweryourexposureto
Theta decay by buying Calls
a little deeper in-the-money.
Depending on how confident
youwereaboutthelikelihood
andmagnitudeofanuptrend,
you might also consider
buying the Calls, a strike or
two out-of-the-money which
would not only limit your
exposure to decay but would
lower your maximum risk as
well. Other times, when the
market might be giving off
signals of an impending
bearish trend, you could just
do the reverse, buy Puts
insteadofCalls.
Stock Trader: How about if
I am just betting on a trend,
not predicting? I just want to
winifthereisatrendineither
direction.
OptionzTraderz:Well,that
isalittlemoredifficult.Long
Strangles and Straddles are
trend grabbers. But their
efficiencyingrabbingatrend
comes at a high cost. The
market is very efficient at
pricing all options and even
more efficient at pricing
combinationsofoptions,such
as Strangles and Straddles.
Chances are the premiums
required to open these types
of trades would reflect the
probability of the underlying
stockpricemovingbynearly
one standard deviation, a
relatively rare scenario. With
Straddles and Strangles,
strongtrendsarethefriendof
an option buyer and the
enemyofanoptionseller.
Stock Trader: I have seen
other option traders discuss
standard deviations and
they’ve always lost my
attention at that point. I
vaguely remember learning
aboutthe‘bellcurve’inhigh
school, and how the curve is
determinedbyusingstandard
deviations, but I have never
fully understood how it
appliestooptiontrading.Isit
really necessary to study
standard deviations in order
to put together an option
trade?
Optionz Traderz: Yes and
no. Standard deviations can
be very helpful, but their use
isbynomeansarequirement
for success. Despite the
complex-sounding
name,
standard deviations are not a
complex subject. I believe I
havefoundasimplemeansof
understanding them. If you
would like, I believe I can
helpexplain.
Stock Trader: Forgive me
for sounding skeptical, but if
you think you can make me
understand
standard
deviations, give it your best
shot.
OptionzTraderz:O.K.,here
goes. Simply put, a standard
deviation is the average
amountofchangeinastock’s
price over a specific amount
of time. Let’s say you are
studying a stock that is
tradingat$25onthefirstday
oftheyear,andoverthenext
365 days it moves up and
downinarangebetween$15
and $35, and ends the year
with a price of $26. Looking
at the closing prices from
each day of the year, you
might find that the average
dailypricewas$27,buteach
day’s closing price deviated
fromthataverage,somedays
by only a few pennies, and
other days by as much as
twelve dollars. You might
also notice that the average
amount that the stock
deviated from that $27 price
was$2.
While it is helpful to know
the average amount that the
daily stock price deviates
from the 1-year average, it is
not so useful in predicting
futureprices.Astockthathas
a move of several dollars in
one day and then remains
nearly flat for the remainder
of the year is actually more
difficult to predict than a
stock that moves up or down
consistently by a few cents
everyday.Inordertoaccount
for the added difficulty
presented
by
large
movements in price, it is
possible to make predictions
by exaggerating the effect of
large price swings in some
fairly simple calculations.
This can be accomplished by
squaring the daily price
deviation from the 1-year
average, averaging the result,
and then taking the square
root of the result. By doing
so, you might find that the
squared amounts average out
to $9 and the square root of
that is $3. That last result is
the most important because
$3 represents the standard
deviation of the stock price.
Based on past performance
the stock can be expected to
bewithinarangeof$3lower
to $3 higher than the current
price after one year of
trading.
Stock Trader: O.K. That
makes sense. But I am not
sure I understand why I
would need to know that in
order to trend trade using
options. Just because the
stock price had a standard
deviation of $3 last year
doesn’t mean it will be the
samethisyear.
Optionz Traderz: You are
exactly right, and you have
just pointed out an important
difference between what we
liketocallHistoricVolatility
and Implied Volatility.
Historic Volatility is simply
the
observed
standard
deviation of the underlying
stock price during a specific
time frame. But the options
marketistooefficienttorely
solely on Historic Volatility
to determine prices. Instead,
options rely on Implied
Volatility, which again
soundscomplex,eventhough
itisreallynothingmorethan
thestandarddeviationthatthe
market is predicting will
occurduringthelengthofthe
upcomingoptioncontract.
The market is very efficient;
ithastobe.Tradersdon’tjust
give their money away.
Millionsoftradersaroundthe
world, many of them
professionals, are studying
thesamestocksasyou,allin
an effort to make as much
money as possible. They are
utilizing
sophisticated
software
to
analyze
performance;
they
are
keeping up with the latest
news and events that could
affect the stock price; and
they are using computerized
trading platforms to execute
their entry and exit points at
theoptimaltimes.Andasyou
just pointed out, just because
a stock had a standard
deviationof$3lastyeardoes
not mean the market expects
it to remain at that level.
Takingintoaccountallofthe
available information on
Earth, market forces might
instead predict a standard
deviationof$5.
Stock Trader: So, let’s
assumethemarketdidpredict
my stock would have a
standarddeviationof$5next
year. First, how would I get
access to this type of
information,andsecond,how
wouldIuseittobenefitfrom
atrend?
Optionz Traderz: A few
days ago we were chatting
about every option contract
having a buyer and a seller.
For every Call seller of your
stock, each believing the
stock would go up by less
than $5 next year, there
wouldbeaCallbuyerwhose
research pointed to a rise of
more than $5. In order to
make a profit, each seller
wouldbehopingtocollectat
leastenoughtimepremiumto
coverhisrisk,andeachbuyer
would be hoping to pay no
morethannecessarytogethis
reward. When the buyer and
sellerwereabletoagreeupon
a price of an at-the-money
Call, it has been my
experience that most of the
time that price would likely
besomewherearound40%of
onestandarddeviation,or$2.
The premium on at-the-
moneyoptionsisusuallyvery
close to 40% of the market’s
predictionofthestockprice’s
standard deviation over the
length of the contract. Or to
put it another way, if you
lookupthepriceofanat-themoney option that expires in
one year and multiply it by
2.5, you will get a rough
estimate of the implied
standarddeviationorImplied
Volatility of the underlying
stock. If the at-the-money
optionsaretradingfor$2,the
marketistellingyouthatone
standard
deviation
is
approximately 2.5 times that
or$5;thepriceofyourstock
at the end of one year will
likely be $26, plus or minus
$5.Thisisimportanttoknow
becauseifyouweretoopena
Long Straddle, you would
probably pay $4 in total
premiums,andthestockprice
would then need to move up
or down by nearly one
standard deviation in order
foryoutomakeaprofit.Most
of the time, stocks do not
exceed a range of one
standard deviation, so this
wouldmostlikelybealosing
trade.
Stock Trader: Wow. I’m
sorryIdoubtedyou.Thatisa
greatexplanation.Soitseems
like it is possible to use a
Straddle to bet on a strong
trend without predicting the
direction.ButIwouldneedto
be confident that a trend was
going to occur because the
trendwouldneedtomovethe
stock price by 80% of one
standard deviation before I
would make a profit. Does
thatmeanIcouldalsochoose
to bet on the direction of the
trendbyjustbuyingaCallor
aPut,andIwouldseegainsif
I the stock moved in that
direction by 40% of one
standarddeviation?
Optionz Traderz: You are
correct. One-sided at-themoney long options usually
requireatrendofatleast40%
of one standard deviation,
while two-sided trades,
although being profitable
twiceasoftenrequireamove
of 80% to be profitable.
Either strategy could work if
the market conditions were
favorable. You might also
consider a Long Strangle,
whichsimplyinvolvesbuying
a Call and a Put out-of-themoney.Theeffectivenessofa
Strangle depends on the
volatilityofthestockandthe
time to expiration, but as a
general rule of thumb,
increasing the strike price of
the Long Call by $1, while
lowering the strike price of
the Long Put by $1, will
lower your initial cost by $1.
Each altered trade saves you
nearly fifty cents, so you are
saving nearly $1 in total
premiumswhilegivingupthe
first$1inprofits.Youwould
be putting much less capital
at risk if the trend never
ensued. Also, in the absence
ofatrend,bothoptionsofthe
Strangle
would
expire
worthless, saving you the
commissions and fees you
would otherwise need to pay
to close a Straddle. In the
case where a trend did
develop,yourprofitwouldbe
nearly identical to a Straddle
because although your profit
would be $1 less per share
thantheStraddle,youpaid$1
lesstoopenit.
Stock Trader: That is very
interesting. A Long Strangle
costs much less to open than
aStraddle,butbothstrategies
work similarly in capturing a
trend. I would not have even
thought to take into
consideration the cost of the
added commissions. I am
reallyenjoyinglearningabout
options from you. This is
such a nice way to spend a
Sundaymorning.
Optionz Traderz: Thank
you. It is so refreshing to be
able to talk about my trading
with someone who truly
seems interested. Sometimes
Italktomypettortoiseabout
options, because he is the
only one who doesn’t get
boredandwalkaway,atleast
notveryfast.
StockTrader: That’s funny!
I don’t think I have ever met
another trader who discusses
his trades with a tortoise. Do
you have any other ideas
abouthowIcoulduseoptions
asatrendtrader?
Optionz Traderz: Let’s say
youwanttobetonatrendin
the triple leveraged exchange
traded fund TNA. It is
currentlytradingat$91atthe
end of July and you can buy
an October $91 Call for $11
and a $91 Put for $11. One
contract of each costs a total
of $2,200, and you capture
100% of the trend, on 100
shares, in either direction.
This particular Straddle
wouldgiveyoucontrolofthe
fullmove,ineitherdirection,
ontheequivalentof$9,100in
underlying stocks, for four
months. But instead of
$9,100, you have reduced
your down side to $2,200
while retaining an unlimited
upside.
Four-month-out
options
are
relatively
inexpensive to hold because
the uncertainty in the market
during that timeframe helps
them retain a fair degree of
time premium; the Theta
decay is very slow. As you
getclosertoOctoberyoumay
experience a price discovery
if a strong trend makes one
sideofyourtradeworthmore
than the original cost of both
options. This is like letting
your
winners
run
automatically with a known
downside, something I have
heard other trend traders
swear by. You lose if the
underlying ETF does not
trend at least $22 in four
months. The good news is
that the efficient market, in
fixing the premium of the
options, has baked-in the
probability
that
the
underlying shares will trend
one way or the other by at
least $11. So you would
realistically only expect to
lose half of your capital if
you were wrong about a
strongtrendandthemarket’s
prediction of the magnitude
ofatrendwasmoreaccurate.
When you analyze the trade
inthismanner,itisasifyou
are putting only half of your
$2,200atriskwhilecapturing
a full trend above $22 on
$9,100 worth of underlying
shares, over a four month
period. In sharply trending
marketsTNAhashistorically
moved as much as $5 in a
single day, and you can
imagine how far it can go in
fourmonths.
StockTrader:Wow!Thatis
a very interesting concept,
capturingafulltrendineither
direction at a preset price. I
likethat.Icanseemanyways
that Straddles could be used
to trend trade. And the best
part is I would not need to
predict the direction of the
trend.
Optionz Traderz: Straddles
are really good trend
grabbers, but they have a
downside, just like every
other
option
strategy.
Because they require the
purchaseoftwoat-the-money
options, they require a move
of nearly one standard
deviation in order to be
profitable. The market is
very efficient in determining
optionpremiums,butitisnot
perfect. Over the long term,
the market is about 68%
accurateinpredictingamove
of one standard deviation.
While that is a respectable
percentage, if it were the
grade on a college exam, it
would at best deserve a ‘D.’
Because a Long Straddle
requires the purchase of two
at-the-money options, each
option
premium
being
approximately equal to 40%
of a standard deviation, the
combined position requires a
move of at least 80% of one
standarddeviationinorderto
generate a profit. The market
gets a ‘D’ trying to predict a
price change of one standard
deviation,andit’sevenworse
atpredictingsmallerchanges.
The chances of the market
correctly predicting a move
of 80% of a standard
deviationarecloserto56%.
Stock Trader: So are you
saying that when I open a
Long Strangle, I will lose if
thestockpricedoesnottrend
at least 80% of a standard
deviation, which is the
amount required to offset
both premiums, and I should
expect a loss 56% of the
time?
Optionz Traderz: Exactly.
Butasatrendtrader,youare
probably already accustomed
to losing most of the time,
right?
StockTrader:Thatisagood
point. Losing trades do not
bother me as a trend trader
because I control my losses
and I always know that my
future gains will eventually
outweighthem.
Optionz Traderz: It works
thesamewaywithoptions.If
you opened the Straddle
usingtheOctoberoptionsand
a trend had not materialized
by September, you could
close it early and cut your
losses. You can also reduce
your losses by reducing the
initial capital you put at risk.
As I was saying earlier, a
Strangleisalmostaseffective
as a Straddle. You use less
money to open a Strangle
withtheunderstandingthatit
usually gives you a slightly
widerpricerange(whereyou
could lose 100% of your
capital) than you would get
withaStraddle.
Sayyoudecidetogoout$11
inpriceonbothsidesandyou
buy the TNA October $102
Call for $7 and the $80 Put
for $7 when the underlying
sharesaretradingat$91.You
now have an outlay of
$1,400, instead of the $2,200
required to open a Straddle.
TNA then has to go up or
down $25 for you to get to
break even, within the next
fourmonths.Theshareshave
to move $11 first to get to
yourstrikeprice,thenanother
$7 to overcome the time
value on your winning side,
and then another $7 to
overcome the cost of your
losing side of the trade. The
Strangle is a slightly less
expensivebet,butwithlower
oddsofwinning;a$25move
has a slightly lower
probability than a $22 move.
But just as with the Straddle,
you could cut your losses by
closingtheStrangleearlyifa
trenddidnotdevelop.
Stock Trader: O.K., I am
going to have to digest that
one mentally; $1,400 could
allowmetocapture100%of
any move on TNA greater
than $11, over a four month
period.
Straddles
and
Strangles seem like they are
good bets for trend traders.
They lose more often than
they win, but the wins are
unlimited.
Optionz Traderz: They are
good long option bets, but
only when the market or a
specificstocktrendmorethan
themarketexpectsduringthe
period of time the option is
valid.Theyarebadlongbets
when markets are stable or
range bound, but good short
bets during those markets.
The expected volatility is
priced in; hence the trend is
accounted for in the option
premiums. No Holy Grail,
justanalternativewaytobuy
into trends at a price that
normally reflects the true
amountofriskinvolved.
Stock Trader: So would
Straddles and Strangles be
best used if I expected a
strong trend, especially when
I believed that the expected
trend was not adequately
pricedintothepremiums?
Optionz Traderz: Yes, that
is correct. In the past, I have
hadsuccessonthelongside,
playing Straddles on volatile
stocks just before earnings. I
limited my holding time to
just the few days around the
earnings announcements to
limit Theta decay. But after
earnings are released, the
baked-in volatility collapses,
so I often had to close my
positions almost immediately
because they usually lost
value very quickly when I
waswrong.
Stock Trader: I think I
understand what you were
tryingtoaccomplish:opening
aStraddlewhenyoubelieved
that the anticipated earnings
wereinsufficientlypricedinto
the premium, then cutting
your losses if you were
incorrect. That seems like a
good plan. You say you did
this in the past. Did
something make you stop
trading this way or are you
still placing the same type of
trades?
OptionzTraderz:Itwasone
of many strategies I have
used.Thesedays,Ipersonally
prefer the short side of
Strangles and Straddles; they
have winning odds of 56%,
on average. When I lose, I
can cut my losses to prevent
big draw-downs. When the
strategywinsforthebuyer,it
sometimeswinsbig,butIcan
often close out before losing
too much on my short
position. I am the winner
mostofthetime.Towin,the
buyer needs to not only
overcome market efficiency,
but also Theta decay and the
Black-Scholes option pricing
model; that is no easy task.
The odds are definitely in
favorofthesellerwinningin
aStraddleorStrangle.Ihave
found that I am more
comfortableasan‘anti-trend’
option trader. I discovered it
to be much less stressful for
metomakeconsistentprofits
and occasionally cut a loss
than it was when I attempted
to weather a series of small
losses in a quest for that one
big win. But that’s just me;
alltradersaredifferent.
StockTrader:SoIguessifI
want to trend trade using
options, I should pick my
Long Straddles and Strangles
carefully. If I comprehend
this correctly, I am probably
going to see losses at least
56% of the time. From what
you told me last week, I
wouldhavetoassumethaton
average my winning trades
would yield about the same
gainsasmycombinedlosses.
If I constantly traded
Straddles or Strangles, I
wouldeventuallybreakeven.
But if I can give myself an
advantage, even if it is a
small advantage, I will
eventuallyseeaprofit.
Optionz
Traderz:
By
George,Ithinkyou’vegotit!
Allyouneedtodoisincrease
your probability of success,
limit your losses, or both.
That’s it! It does not matter
whether you are trading
stocks, options, futures,
commodities, or any other
instrument; the rules are the
same. Increase your wins,
decreaseyourlosses,orboth!
It’sthatsimple.
Stock Trader: The 56%
losing odds of a Long
Straddle seem a bit daunting.
I may have to reconsider
whether that strategy would
work for me. As a trend
trader, I usually have to deal
with some losses, but I was
hoping to find an option
strategy that would give me
betteroddsthanthat.
Optionz Traderz: Straddles
and Strangles reflect the
combinedpredictionofevery
traderontheplanetregarding
themagnitudeofatrend;itis
very difficult to outwit the
entire market and overcome
the odds. I think that is the
reason I started trading Short
Straddles. The confidence of
having56%oddsinmyfavor
and the relatively small
number of trades required to
cut my losses suits my
personality.Asatrendtrader,
you might want to consider
LongCallsorPutsinstead.If
you can predict the direction
ofatrend,aLongCallorPut
isamuchbetterchoicethana
Straddle or Strangle. The
premium of an at-the-money
option is about 40% of a
standard deviation, and the
market is only about 38%
successful in predicting a
trendthatprecisely.Notonly
does the option market do a
poor job of predicting the
magnitudeoftrendswiththat
degree of accuracy, but it
does even more poorly
predicting the direction of a
trend. If you can predict the
direction of a trend, you can
double your odds on a Long
CallorPut,ineffectreducing
the market’s odds from 38%
to 19%. That means a Long
Call or Put, at-the-money,
willmakeyouaprofit81%of
the time if you are correct
about the direction of the
trend.
StockTrader: Itsoundslike
ShortStranglesandStraddles
have given you a consistent
way to make money betting
against a trend. But if I want
to trend trade with options,
maybe Long Straddles and
Stranglesarenotthebestway
todoit.Inmystocktrading,I
use charts of moving
averages and volume to help
medeterminethedirectionof
a trend, so I think I might
take your advice and stick
with one sided option trades.
81% odds are what I was
lookingfor.
OptionzTraderz: Onesided
option trades are highly
suitablefortrendtrading.The
option market is very
efficient at predicting the
future price movement of
stocks,butmuchlessefficient
atpredictingthedirectionofa
trend.Iliketothinkofitthis
way: the market looks at
volatility more as a fear that
prices will fall, rather than a
fear that prices will merely
change. What this means is
that most of the time Put
option premiums reflect the
combined fears of every
traderintheworld.Putsellers
fear an increased risk and
raise their ask price. Put
buyers see an increasing
opportunity and raise their
bids.Ontheotherhand,most
investorsdonotfeelthesame
fear when they think about
prices going up. So, Call
option premiums, while they
should reflect the ‘fear’ of
rising
prices,
instead
represent the required parity
with Put options. If Call
options truly represented the
‘fear’ of rising prices, they
would
become
more
expensive in bull markets.
Butinanup-trendingmarket,
where fears decrease, in turn
driving down the premiums
on Put options, Call
premiumsmustalsodecrease.
If the price of Calls did not
decrease in parity with the
Puts, it would be possible to
make free money by buying
stocks,alongwithlowpriced
Puts, while selling higher
pricedCallsatthesamestrike
price. Free money is not
something that an efficient
markettolerates.Theresultis
thatinanup-trendingmarket
in which traders tend to be
less fearful, the premiums on
all options, including Calls,
mayactuallydecrease,giving
a trend trader a perfect Callbuyingopportunity.
PennyPumper:Yougotthat
backwards.Calloptionprices
go up when the stock price
goesup.
Optionz
Traderz:
I
apologizeifIdidnotexplain
that clearly enough. What I
meant was that the premium
of an at-the-money Call
during a down-trend is often
higher than the premium of
an at-the-money Call in an
up-trend. If a stock quickly
declinesfrom$50to$40,the
$40 Calls might be priced at
$5, but when the same stock
rebounds to $50, the $50
Callsmightonlycost$4.
Penny Pumper: Or you
could just avoid options
altogether and buy ZXLL
before the 1600% increase
that is certain to occur next
week.
Stock
Trader:
Penny
Pumper: If you are making
1600% returns, what are you
doing pushing stocks on
Facebook?Youshouldbeout
enjoying your yacht. Good
grief! Optionz Traderz: I
never thought of the price of
Long Calls becoming more
affordable in an up-trend.
That would be a gift to a
trendtrader.
OptionzTraderz: I agree. It
issomewhatlikeagift.Calls
are often under-priced in a
true rally. Straddles and
Strangles are cheaper to buy
in an up-trend as well, but
theygetratherexpensiveina
downturn. In a down-trend it
is sometimes better to use a
Long Put instead. I have
tradedoptionsthatwayinthe
past.Whenthatlastmajoroil
spill occurred, I did not open
a Long Straddle. I bought
Puts only, on the oil
company’s stock that was
responsibleforthemishap.
StockTrader:WhatIthinkI
like most about trend trading
with options is that I can
control my risk. If I want to
risk2%ofmytotalcapitalon
a trade, instead of setting a
2% stop loss on the stock I
canjustbuyoptionswith2%
of my capital. I can then let
thestockpricefluctuatemore
withouttheriskofastoploss
being tripped. My down side
islimitedtothesameamount
I would have risked buying
the stock, but I still capture
the full upside of a
movement.Ireallylikethatit
alsoenablesmetostretchmy
equity into more positions, if
Idecideto.
Optionz Traderz: Option
trading is really not much
different than stock trading.
Bothcanbedoneusingmany
different strategies and both
areallaboutriskandreward.
If you wanted to buy 1,000
shares of TNA at $91, you
wouldneedtoputup$91,000
and use a stop loss of about
$2inordertorisk2%ofyour
capital. I don’t know about
you, but a $2 stop loss on
shares
that
sometimes
fluctuate$5inasingledayis
much too close for my
comfort. To try to simulate
the same position, you could
use Long Calls. But I should
point out that it is not as
simple as just taking your
$2,000, the amount you
would have risked on the
shares, and using it to buy
options. By doing so, you
wouldbeforcedtoeitherbuy
10 contracts far out-of-themoney, or settle for a much
smaller number of contracts
at-the-money. Let’s say the
October $91 Calls on TNA
were still selling for $11; the
only way to catch the same
trend as if you owned 1,000
shares would be to open 10
contracts at-the-money, and
that would cost you a
whopping $11,000. But that
is far less than the $91,000
you originally needed. As
always, not wanting to risk
morethan2%ofyourmoney,
you would need to employ
some sort of stop loss. The
good thing here is that four-
month-out option prices, atthe-money, initially only
moveabouthalfasfastasthe
underlying shares. It is likely
thatitwouldtakea$4decline
in TNA to result in a $2
decline in your Calls, so you
could set your stop loss
farther away than you would
if you owned the actual
shares. In effect, this gives
you double the amount of
protection
against
immediately being stopped
outbywhipsaw.
Stock Trader: I see what
you’re getting at. Options
aren’t so much about
reducing risk as they are
about changing the way the
riskwillaffectatrade.Inthe
case of using Long Calls in
place of long shares, I would
be taking away a lot of the
‘risk of ruin’ in case of a
sudden, violent, downturn
becausemymaximumlossis
reduced from $91,000 to
$11,000. Another benefit
wouldbelesseningofmyrisk
of being stopped out by
whipsaw.
But
those
reductions of risk would be
balancedbytheincreasedrisk
Iwouldbetakingbyopening
myselfuptotimedecay.
Option Trader: Again, you
are correct, and I have more
good news. There are many
different ways to trend trade
with options while also
choosing exactly the type of
riskexposurewithwhichyou
are comfortable. Maybe you
wouldn’t be able to stomach
risking $11,000 on an all-ornothing trade, even though
you were confident in your
abilitytospotatrend.Despite
your trust that you were
protectedbyyourstoploss,a
fear of the shares gappingdown, falling in price
overnight and opening the
nexttradingdayatapricefar
below your stop loss, might
make you lose sleep. As an
alternative,youmightinstead
consider opening a Vertical
Spread: buying ten October
$91 Calls for $11,000 and
selling ten $95 Calls for
$9,000. Your maximum risk
would be locked-in at the
same amount you previously
decided was appropriate,
$2,000.However,yourtradeoff for locking in the
maximum loss would be a
reduction in your upside
potential to a maximum of
$2,000. Another trade-off
with Spreads is that they
respondveryslowlytotrends
in the underlying; and while
this would allow you to cut
yourlossesveryefficientlyif
thetrendwentagainstyou,it
would also mean that you
wouldneedtoholdontoyour
winners right up until
expiration to see the full
benefitofatrend.
Stock Trader: I never
imagined there would be so
many ways to trend trade
usingoptions.Itisinteresting
to see that option traders are
abletochoosethetypeofrisk
thatmakesthemcomfortable.
When I trade stocks, I use a
method of risk management
thatreducesmystress.Ihave
foundthatwhenIdonotfeel
stress trading stocks, I am
able to stick to my proven
system and avoid allowing
myemotionstotemptmeinto
tradingatthewrongtimes.If
Icanfindasystemoftrading
options that makes me
comfortable, I imagine I
shouldbeabletosticktoitas
well.You’vereallygivenme
some new ideas to think
about.Well,Idon’twanttake
up your entire Sunday, but I
am interested in learning
more.
OptionzTraderz:Youaren’t
wasting my Sunday. I really
enjoy talking with you about
options. I’d like to talk a
while longer, if that’s O.K.
with you. But I probably
shouldgetgoinginawhile.It
issuchaniceday,andmypet
tortoiselikestotakewalksin
theyardwhenit’ssunnylike
this.
Stock Trader: I won’t take
up any more of your time. I
need some time to myself to
mentally digest what you
have said. Having developed
a stock trend trading system
that served me well, I guess
all that I need to do now is
learn how to apply those
same principles to develop a
system using options. I am
almostashamedtoadmitthat
the option market once
seemed so much different
thanstocksthatitprovokeda
fear of the unknown, even
though I have been trading
stocksforsomanyyearsthat
I feel I should no longer be
afraid of anything. It was
almostasifstockswerefrom
Mars and options were from
Venus. But after talking with
you, it is now apparent that
both markets have the same
goal: avoiding risk and
generatingincome.
Optionz Traderz: I agree.
Stock options are the best
way I know of generating
income while controlling the
risks of trading. Many stock
traders are just too afraid of
time decay to even consider
lookingatoptions.
Stock Trader: I am no
longerscaredofoptions.Iam
fascinated with all the
possibilitiestomakemoney.
Optionz Traderz: Good to
hear it! I’ll leave you with
one more option trend trade
to think about before I go: a
Synthetic Long or Short. To
go long, instead of tying up
$91,000 on those shares of
TNAyoumighthavewanted
to purchase, you could have
bought ten $91 Calls for
$11,000, and sold ten $91
Puts for $11,000. The trade
would have cost you nothing
to open, but it would have
behaved nearly exactly the
same as owning 1,000 shares
outright, assuming you met
your
broker’s
margin
requirements.Itwouldbelike
betting on a trend with free
money. If you had been
bearish,youcouldhavedone
the opposite, created a
SyntheticShort,bybuyingatthe-money Puts and selling
Calls at the same strike.
EnjoyyourSunday!
Stock Trader: That sounds
almost too good to be true,
betting on a trend without
putting any money upfront.
Enjoy your Sunday too, and
have fun walking your
tortoise.
PennyPumper:Ifyoureally
want to catch a great trend,
buyZXLLnow!
Penny Trader: I agree. One
dollar,herewecome!
Stock Trader: And I am
selling both of you guys
short.
Optionz Traderz: Those
guys are so annoying. Your
postsummedupmythoughts
perfectly. Way to go, Stock
Trader!
Chapter4
TIMEISAN
OPTION
SELLER’S
FRIEND,BUT
THEOPTION
BUYER’S
ENEMY.
(THETA)
“Monday morning…
great,” thought Stock Trader
as he was roused from his
blissful sleep by that
annoying alarm clock. It was
time to get to work so he
couldpayhisbills.Everyday
he pondered how he could
create a steady stream of
income to pay his bills
withouthavingtosellhisown
personal time for money.
Even with all his success in
the stock market and a hefty
account size, he lacked the
confidence to trade for a
living. He rationalized to
himselfthatthereasonforhis
fear was justified because
traders had losing years, and
his type of trend trading was
more suited for long term
capital appreciation than for
meeting
daily
living
expenses. Long ago he had
written in his trading journal
the secret formula for
winningasatrendtrader.
The Market Trends =
I make money as a Trend
Trader.
No Trend in the
Market = I lose money as a
TrendTrader.
He smiled as the
memory of that revelation
cametomind.Whenhewasa
newtrader,hisegohadtobe
right. He felt like a failure if
he took a breakout in a hot
stock and it floundered and
retraced back below the
breakout. He eventually was
able to accept that a loss
simply meant that his system
didnotwinonthatparticular
trade,anditdidnotmeanthat
he was a loser. He had
learnedtoseparatehissystem
andmethodfromhisego,and
that meant he didn’t need to
berighteverytime.
BabeRuthdidn’thita
homerunduringeveryat-bat,
and he didn’t fall into a
depression every time he
struck out. Hall of Fame
baseball players didn’t win
every game; they simply had
excellentstatistics.
His morning routine
was on auto pilot: shaving,
showering, and dressing. He
was not thinking about the
routinebecausehismindwas
pondering options and all
theirmovingparts.
“I wonder if option
trading is just like trend
trading. If you use the right
system in the right market
environment, you make
money. The market behavior
istheultimatedeterminantof
whether you make money,
not your inherent trading
genius,” thought Stock
Trader.
On his commute to
work, he was frustrated that
he was selling his own
personal time for money, or
maybe it was the realization
that he was just not getting
enoughmoneyforthetimehe
wasdedicatingtowork.
Then he had a
revelation. Option sellers
werejustsellingtime.Option
sellersweresellingtherights
to own stocks at a specific
priceforasetperiodoftime.
Option buyers were simply
buying time. Of course, this
time value was based on
many factors, such as the
stock’sHistoricalandImplied
Volatility, time to expiration,
and the amount of intrinsic
value already present in the
option. Option sellers, it
seemed, were just selling the
rightstocontrolasetamount
of shares. They were selling
the right to leverage stocks
foraspecifiedtimeperiod.
Thesellergetstokeep
the‘timepremium’nomatter
what happens. That is the
seller’s defined maximum
gain. The buyer receives the
full profits of the stock he
controls, if there are any, but
his maximum loss will
always be the time premium
he paid to control the stock
position. Intrinsic value is a
separate
consideration
because
it
functions
differentlythantimevalue.
In his mind he could
seesandsrunningthroughan
hour glass. Options are not
assets
because
they
deteriorate as time goes by
and go to zero if there is no
intrinsic value at expiration.
That was one of the things
that had always scared Stock
Trader away from options.
They truly were defined bets
over a period of time for
whichbuyershadtopayaset
amount. They were not
assets; they were tools.
Stocks did not expire or lose
valuedueonlytothepassing
oftime,butoptionsdid.
Stock
Trader
was
sitting on the interstate in
bumper to bumper traffic on
his way into the city. “If I
was trading from home, I
would not have a morning
commute in rush hour,” he
thought.Moreofhisprecious
time was being wasted, and
this was now his morning
routinealmosteverydaythat
he worked. “If I was a stock
option I would expire,
worthless, before I got to
work,”hethought.
“Wastherealheartof
all option trading nothing
more than the buying and
sellingoftime?”hepondered.
“With stocks, you can only
golongandshortonprice;is
itpossibleinoptiontradingto
golongandshorttime?”Ifhe
was able to survive this
horrendous commute and
finallymakeithome,hisfirst
priority would be to find out
what Optionz’ thoughts were
about the element of time on
tradingoptions.
After a long day at
work, followed by two
grueling hours on the
interstate, Stock Trader
finally arrived home. He
retrieved a nice cold beer
from the back of his
refrigerator. Like most
bachelors, he had the typical
grocery stock: beer, pizza,
chips, dip, and a few frozen
items. But his mind was not
focused on food; it was
focused on options. He did
not even want to let the
financial network’s talking
heads catch him up on the
day’s fundamental news and
prices. All he wanted to do
waslearnmoreaboutoptions.
“What did those guys
really know about trading
anyway?” While some of
them started out as traders
and became journalists, the
majorityofthemweremerely
journalists reporting the
financial news. He thought
most
of
them
were
hypocrites,
not
even
following their own advice.
While reporting on investing
and trading, they were
actually invested in their
good old buy-and-hold
401Ks. He occasionally
watched financial news
networks,
mostly
for
entertainment,likesportsfans
watchsportschannels.Hedid
not need journalists to tell
him how to trade; charts told
himallheneededtoknow.
Stock Trader finished
his beer and realized he
wasn’t really hungry, so he
skippeddinnerandwentright
tohiscomputer.
Afterhemadeittohis
Facebookaccount,heclicked
on his Winning Traders
group. He saw that he was
joinedby:
GhostofDarvas
OptionzTraderz
PennyTrader
PennyPumper
RookieTrader
TrendMan
Ghost of Darvas: So if I
believedastockwasgoingto
break out to a new high, I
could buy the stock’s Call
optionandgetahugeamount
of leverage with much less
capital?
Optionz Traderz: Yes, and
also a much bigger
percentage return on the
capitalyouareusing.Youdo
not have to purchase the
options until the stock
actually breaks out. But if
you do buy options at the
priceofthebreakoutandyou
are correct, then you get the
full intrinsic value of the
move above the breakout,
after having bought the
options for their time value
only.
GhostofDarvas:SoallCall
options that are higher than
the current price of the stock
are only worth time value?
Howistimevaluederived?
Optionz Traderz: The time
value is based on variables,
like Historical Volatility and
Implied Volatility, current
price of the underlying asset,
strike price, risk free rate of
return and the probability of
the option being in-themoney. There is a complex
formula, which is probably
only understood by math
whizzes, but you can get a
good understanding of a
stock’s Theta value be
looking at an option chain.
The at-the-money options
have the highest time value
becausewhentheyareat-themoney, they have a 50/50
chance of going in-themoney.Asyougofartherand
farther out-of-the-money the
probability becomes less and
less. It is possible that a two
strike
out-of-the-money
optionmightonlyhavea25%
chance of going in-themoney, so it could be priced
athalfasmuchastheat-themoneyoption.
Ghost of Darvas: What
about in-the-money options
timevalue?
Optionz Traderz: If you
look at the in-the-money
options in the chain you will
noticethatthetimevaluegets
lessandlessasyougodeeper
and deeper in-the-money. Go
deep enough in-the-money
and you will have pure
intrinsic value and no time
value.
Ghost of Darvas: I do not
understand that. Why would
anyone buy or sell an option
withalmostnotimevalue?
Optionz Traderz: Hedging,
leverage, and locking in
gains;therearemanyreasons.
The reason that there is little
time value in deep in-themoneyoptionsisthatthereis
very little chance that they
will expire worthless. At
expiration the value of these
options is not determined by
whether or not they are inthe-moneybuthowdeepthey
are in-the-money. Trading
deep in-the-money options is
almostthesameastradingthe
stock itself, which has zero
timevalue.Thevalueofthese
options is almost entirely
dependent on the movement
ofthestock’spriceregardless
of the amount of time that
passes, whereas the passage
of time has an equal chance
of causing at-the-money
options to either expire with
intrinsic value or worthless.
The buyers of these options
can get the full move of the
underlying with a relatively
small amount of capital
compared to trading the
shares at their full value.
Thosebuyershavetheriskof
the price moving in the
opposite direction, but their
risk is much more limited
than being long or short the
underlying shares; and
becausetheoptionshavevery
little time value, they
experience very little time
decay. For example, Call
sellershavealreadybeenpaid
to give up any upside trend,
but instead of selling time
value, as they would with atthe-money options, they are
selling intrinsic value. As
longastheunderlyingshares
do not increase in price, the
sellers make a profit. Some
traders and investors may
want to delay trading their
stock because of tax
consequences, so they sell a
deep-in-the-money
option
against their position to lock
in the gain for a period of
time.
Ghost of Darvas: It is
interesting that the Darvas
stockoptionsIhavelookedat
are very cheap when buying
themout-of-the-moneyatthe
next possible price breakout.
Why is that? I would think
thattheoptionsforthehottest
stockswouldbeexpensive.
Optionz Traderz: The
pricing for those options is
based on the probability that
they will be in-the-money at
expiration. As a Darvas style
trader,youknowthatsomeof
the best opportunities for
buying stocks are when they
are trading in a range for
several days, and then break
out above that range with
high trading volume. When
those stocks are stuck in a
pricerange,theprobabilityof
abreakoutisperceivedtobe
low, so the Call options with
astrikepriceatthetopofthat
rangeareusuallyfairlycheap.
Ghost of Darvas: Are you
sayingthattheoptionpricing
reflects the probability of the
optionbeingawinner?
Optionz Traderz: Yes and
no.TheBlack-Scholesoption
modeldeterminespricing,but
there are also supply and
demand pressures in the
optionbeingtraded.Onsome
underlying stocks there are
very few options traded, and
this has a huge impact on
prices. Be sure to be careful
withlowvolumeoptions;the
bid/ask spreads could really
eatintoyourprofits,resulting
in large percentages losses
when buying and selling.
Gravitate toward the most
liquid options on your watch
list. With so many to choose
from, there is no reason to
addtheriskoflossduetothe
bid/ask spread to the list of
things that you need to
overcome in order to be
profitable.
Ghost of Darvas: Good
point.Ineverreallylookedat
thepricespread.Someofthe
hot stocks on my watch list
aresmall-capupandcomers,
with low trading volume and
even lower volume on the
options, and many do not
haveoptionsatall.Oneofthe
stocks I have been following
hasat-the-moneyCalloptions
withabidpriceof$4.00and
an ask price of $5.10. That
means if I bought 10
contracts at market price I
would pay $5,100, but if the
trade immediately went
againstme,Iwouldbeforced
to sell for $4,000, or less. I
could lose more than $1,100
in one day, due almost
entirelytothebid/askspread.
IguessIwillhavetobevery
selective.Butyouhavegiven
me some great ideas for a
Darvas-style trading system
usingstockoptions.
Optionz Traderz: Glad I
couldhelp.
Stock Trader: It’s good to
see some honest traders in
thisgroupforachange.Asa
trend trader, I often use the
Darvastechniqueasaguide.
Ghost of Darvas: Darvas
was a genius. His trading
system is so simple, but it
workssowell.Allitinvolves
is watching a stock when the
price range is inside a ‘box’
and then buying it when it
breaks out above the box,
using a stop loss for
protection.NowIamlooking
for a way to trade the same
way,butwithoptions.
Stock Trader: Same here. It
looks like Optionz Traderz
had some good advice for
you.
GhostofDarvas:Definitely.
I’m glad I joined this group.
I’monmywayoutrightnow,
but I’d be interested in
sharing ideas on Darvas
tradessometime.
Stock Trader: That sounds
good. I’m here in the
Winning Traders group
almosteveryday.
Optionz Traderz: You two,
getaroom!
StockTrader: Veryfunny.I
guess you like to use options
totrademanydifferentways.
Optionz Traderz: Good to
see you online. Yes, they are
great tools to have in my
toolbox. The problems with
some option traders is they
onlywanttotradethefaroutof-the-money lottery tickets,
looking for the big win and
not even considering all the
differentwaystotrade.When
all they want to do is knock
theballoutofthepark,every
ball looks like it is in the
strikezone.
Stock Trader: I have seen
this also. Many of them also
onlytalkabouttheirbigwins,
not about all the losses they
had that were twice as much
as their wins. It’s just like
somegamblers,whotellonly
about their winning trips to
Las Vegas, while quietly
losingonalotoftheirbets.I
thinkalotofpeopletradefor
the adrenaline rush and the
sportofit.
Optionz Traderz: I only
tradeforthemoney.
Stock Trader: Me too. Do
you have any ideas about
ways to make Theta trades
withoptions?
Optionz Traderz: Well,you
know long options are long
Theta and short options are
short Theta. Each day an
optiondeterioratesattherate
ofitsTheta.Anoption’stime
value is usually, but not
always, worth less at the
closethanitwasworthatthe
open because the time
available for it to be
profitable is less by one day.
If the underlying price
remains stable, an option
contractwithaThetaof-0.12
will lose $0.12 of its value
everyday,evenonweekends
and market holidays. This
rate of decay accelerates in
the last month before
expiration, as the odds of the
underlying price changing
become much lower as
expiration day approaches.
Many option traders avoid
goinglongoptionsinthelast
month to avoid the majority
ofthetimedecay.Also,many
option traders like to sell
options in the last month
before expiration so they can
profit from time decay. I
sometimes
sell
weekly
options where Theta is very
generous.
StockTrader:Ihavenoticed
the acceleration in time
decay. It almost seems like
every time I buy options,
Thetaeatsupthevalue,even
when I am correct about the
direction of a trend. I
understand how Delta works
with options, but Theta has
always been a more difficult
subjectforme.Awhileback,
Ibought1,000sharesofstock
onabreakoutanditdidreally
wellinthefirstweek.Butthe
gainswereallonlowvolume,
so I was fairly confident that
the trend was going to
reverse.Iwasn’treadytosell
atthatpointbecausethestock
was only a couple of weeks
away from the ex-dividend
date and holding onto the
shares would have qualified
me for a substantial profit.
Thinking that I could lock in
the profit by buying at-themoney Puts, I looked up the
Greeks. The Puts showed a
Deltaof0.50,soIbought20
contracts. I thought I was
Delta-neutral; if the stock
price went down $1, I would
lose $1,000 of my gains on
my 1,000 shares, while my
Putswouldgoupinpriceby
fiftycentsbecausetheirDelta
was0.50;andbecausemy20
contracts covered 2,000
shares, I thought I would
recover that $1,000. As it
turned out, I was partially
correct. The stock price fell
$1 over the next week, but
my Puts only went up in
value by $500. I ended up
selling everything at a $500
loss and that caused me to
alsomissoutonthedividend.
It seemed like I made the
right decision, creating a
Delta-neutral position, but
Theta decay ate up all of my
profits.
Optionz Traderz: Time
decay, or Theta, is really the
mostimportantconceptinall
of option trading. Option
pricesaredeterminedbyrisk,
and risk in the markets is
simply a factor of the
uncertainty of how time will
affect prices. Delta, Gamma,
Vega, and all of the other
Greeksarenothingmorethan
different ways of expressing
the effect of the time related
riskofbeinglongorshorton
any particular option. An
understandingofThetaisthe
key to success with options.
You can spend time
researchingalloftheGreeks,
but in the end, I think you
will find, as I have, that they
are all derivatives of Theta. I
discovered option trading to
bemuchsimplerwhenImade
Thetamymainfocus.Ithink
Thetamaybethereasonyour
trade failed, and I may be
able to pinpoint what went
wrong,ifyoulike.
StockTrader:Thatwouldbe
great.
Optionz Traderz: You were
correct in your assumption
that your position was Delta
neutral, at least initially. But
your position was not Theta
neutral; the time value of the
options you purchased was
decaying every day you
owned them. To be Theta
neutral, you would need to
sell time value in order to
offset the time value you
were buying. Instead of
buying 20 Put contracts, you
could have made your
position Theta neutral by
buying10Putsandselling10
Calls. But I should point out
thattheoptionmarketisvery
efficient, and it considers
everything that affects the
priceoftheunderlyingstock,
including dividends. On the
ex-dividend date, a stock is
expected to fall in price by
the amount of the dividend,
or at least a portion of that
amount. That makes Puts
more expensive than they
would be otherwise, while
Calls get cheaper. It is likely
that buying 10 Puts at an
inflated price due to the
anticipated dividend and
selling 10 Calls at a
discountedpricewouldresult
in a net cost approximately
equaltothedividend.
Stock Trader: I think I get
whatyouaresaying.Inorder
to use options to lock in the
gains on my stock I would
need to use a strategy that
was Theta neutral, so that I
would not experience time
decay.
Optionz Traderz: Exactly,
and there are other strategies
thatareThetaneutralorvery
close to it. You could have
simply bought deep in-the-
money Puts with very little
time value; but again, the
price of those Puts would
have been inflated to reflect
the decline in price that was
expected on the ex-dividend
date.
Stock Trader: So I guess
options are not usually good
tools for locking in gains. I
probably would have done
just as well selling the stock
when I saw weakness, rather
than try to protect my gains
usingoptions.
Optionz Traderz: Exactly!
But there are times when
usingaThetaneutralposition
to lock in your gains might
comeinhandy.Let’ssayyou
just had a great year in the
market and have a huge
amount of unrealized gains
that are all taxable. It is
possibletouseoptionstolock
in those gains, but delay
realizing the gains until the
following tax year. You can
Synthetically Short your
gainers by selling a Call and
buying a Put at the same
strike price, but use options
that expire after the current
tax year. You would still sell
each stock with all of its
gainsintact,butyouwouldbe
delaying the sale, and that
could save you a bundle on
taxes. The position is Theta
neutral, so you would not
experiencetheeffectsoftime
decay.
StockTrader:Wow,Inever
thought about using options
to save money on taxes. But
I’m more interested in
learning how to profit from
Theta. Do you have any
ideas?
OptionzTraderz:Ofcourse,
you probably would want to
sell options when the Theta
decay takes place the fastest,
the last month. Some traders
even like trading the weekly
options, which have even
greater Theta decay. You
could sell out-of-the-money
options that you believe are
above resistance and have a
very low probability of
getting there. You could sell
those sucker bets, which is a
high probability system, or
youcouldsellbothCallsand
Putsat-the-moneyonastock.
This puts the odds in your
favor – a Short Straddle, like
we talked about yesterday.
There is also a play called a
Calendar Spread, where you
buy a long term option and
then sell a short term option
atthesamestrike.Youprofit
fromthefastertimedecayof
the shorter term option
compared to the longer term
option. The only losing
scenario on a Calendar
Spread occurs when the
underlying shares move a
hugeamountintheshortterm
and then level off or reverse
thetrendinthelongterm.
StockTrader:Hmm,thatall
makessense,puttingtheodds
in my favor and benefiting
fromtimetickingaway.ButI
still don’t fully grasp the
concept of Theta. Why is it
that stock options with a
monthly expiration only cost
about twice as much as
weekly options; shouldn’t
theycostfourtimesasmuch?
Optionz Traderz: Theta is
not as difficult to understand
as you might think, and it
really is important to
understand Theta to be
successfulwithoptions.Ican
try to explain, if you would
like.
Stock Trader: Here we go
again. I know I shouldn’t
doubtyouanymore,sogiveit
yourbestshot.
Optionz Traderz: Time
value simply represents the
uncertainty of what effect
time will have on a future
event. I was thinking about
time value just this past
weekend. I had taken my pet
tortoise for a walk and was
sitting by the pool enjoying
mymargaritawhenIrealized
he had wandered off. I
quicklygotsomeoftheother
condo owners to help me
searchandwestartedfanning
out in all directions. Luckily,
wefoundhimafterjustafew
minutes, but we had to cover
alargeareatodoso.
Stock Trader: I’m glad to
hearit.Iknowhowmuchyou
like your option trading
buddy. But what does a
tortoise have to do with
options?
OptionzTraderz:Thinkofit
this way. My tortoise usually
walksveryslowly,constantly
changes
direction,
and
sometimes stops altogether,
just as stock prices do. But
when he wandered away, the
areawehadtosearchbecame
largerandlargerastimewent
by.Thesearcharearepresents
theuncertaintyofhislocation
duetothepassageoftime.As
itturnedout,wehadtosearch
a rather large area, but in
reality he was not very far
away when we found him.
Ultimately, it is his distance
from my chair that normally
concerns me; his distance
frommychairbythepool.It
isthesamewithoptions.You
are not concerned with the
amountofareaofuncertainty
oftheunderlyingpriceduring
thecontract,onlythedistance
thepricemightmovefromits
startingpoint.
Stock Trader: I follow you
so far, but I don’t yet
understand how it relates to
Theta. You have not
disappointed me with your
pastexplanations,sogoon.
Optionz Traderz: O.K., so
we all remember learning in
math class how the area of a
circle is πR². I even had one
math teacher who would
always follow that equation
with the remark, “No, they
aren’t;pieareround.”Idon’t
think any of us ever laughed
at his attempt to be a
comedian,butitwashisway
of trying to get us to
remember the equation. It is
importantbecausetheareaof
a circle is related to the
squareoftheradius;ortoput
itanotherway,theradiusofa
circle is related to the square
rootofthearea.Iftheareaof
a circle becomes four times
larger, the radius doubles
because 2 is the square root
of 4. So when we were
searching for my tortoise, as
time went by we had to
expand our search over a
larger and larger area, even
though his distance from my
chairwasnotincreasingvery
fast. Think of the effect of
time on stock prices like the
search area for a tortoise. As
time goes by, the area of the
circle that would represent
the search area grows, but
you are only concerned with
thedistanceofthestockprice
from its starting point, which
isthesquarerootofthatarea.
The distance of a stock price
from its starting point is its
‘speed’
or
volatility,
multiplied by the square root
oftime.
StockTrader:NowIthinkI
am starting to understand.
Stock prices don’t just go up
or down consistently; they
meander around, like your
tortoise does when you take
him for walks. So while they
coveralargerandlargerarea
astimegoesby,thepricesdo
not change nearly as fast as
the area they cover. If I
understand
correctly,
predicting a stock price four
weeks away would involve
four times the search area of
predictingthepriceoneweek
away.Butthesquarerootof4
is2,sotheuncertaintyofthe
price four weeks out would
be about double the
uncertainty of the price a
weekaway.
Optionz Traderz: Exactly. I
liketalkingwithyoubecause
youareaveryfastlearner.
Stock Trader: Thanks, you
are a good teacher. If I
understand your analogy, it
explains why a lot of the
monthly options are about
double the price of weekly
options
because
the
uncertainty is not four times
as much, but two times
greater.
Optionz Traderz: Yes, but
only for at-the-money and
out-of-the-money
options.
Intrinsic value on in-themoneyoptionsisthesameno
matter what their expiration
date. So although the time
valuewouldstillbedoubleon
the monthly in-the-money
options, the actual premium
would not be twice as much
astheweeklyonesbecausea
portionofthepremiumwould
bebasedonthesameintrinsic
value. Deep in-the-money
options, having very little
time value, might have
similar premiums despite
having different expiration
dates.
StockTrader:That’sagood
point.Itisonlythetimevalue
ofanoptionthatisdependent
ontheexpirationdate.Would
the same process apply to
other expiration dates? Does
anoptionexpiringinoneyear
havedoublethetimevalueof
an option expiring in three
months?
Optionz Traderz: Yes and
no. Using the square root of
timeasadifference,youwere
correct in your assumption
that because 12 months is
four times as long as 3
months,youwouldexpectthe
furtheroutoptionstohavethe
square root of four, which is
two, times the time value.
However, that is not always
the case in the real world;
option
premiums
are
determinedbyaveryefficient
market. For example, the
market might be predicting
lowvolatilityinthenextthree
months
but
increasing
volatility over the coming
year. In such a scenario, the
longer term options might
havemorethantwotimesthe
time value. But as a general
rule, you are correct; a
contract with an expiration
date 12 months away will
have
a
time
value
approximately double that of
athree-monthcontract.Ihave
a chart that shows the effect
of the expiration date on
Theta.I’dbehappytoshareit
ifyoulike.
Stock Trader: Sure. I’d be
interested in seeing it. I
alreadydoalotofmytrading
based upon charts. I know
some traders who don’t use
charts at all, but I prefer
them. To me, charts are a
trader’sbestfriend.
OptionzTraderz:Iagree.I
can’t imagine what I would
do without charts. I’m
sendingitnow.
Astimepasses,thesearcharea
doubles,butthepredicteddistancefrom
thestartingpointistheradiusofthe
searcharea,whichisproportionalto
thesquarerootofelapsedtime.
StockTrader:Thatisagreat
chart. I always thought of
stock prices moving in only
two directions, up or down.
ButIcanseehowpicturinga
stock price like a tortoise,
movingleftandright,aswell
asupanddown,makessense.
The area where the stock
pricewillbein10minutesis
twicethesizeoftheareaafter
fiveminutes,butthedistance
from the center does not
double because the radius
increases at a rate equivalent
to the square root of time. I
think I am finally starting to
understand Theta now; it is
likethesquarerootoftime.
Optionz Traderz: You
nailed it. Theta is a
logarithmic
function,
equivalent to the square root
of time. I have two more
chartsthatshowtheeffectof
time decay on an option.
They are basically the same
chartinreverse,butyoumay
find them helpful. I’m
sendingthembothtoyou.
Thetimevalueofoptionsisbasedupon
theuncertaintyofthepriceofthe
underlyingstockduetothepassageof
time.
Asexpirationdayapproaches,options
losetimevalueatanacceleratingrate.
Amonthlyoptionmaylosehalfofits
timevalueduringthefinalweekof
trading.
Optionz Traderz: I should
alsomentionthatthesecharts
onlyapplytooptionsthatare
at-the-money. Time value is
alwaysthegreatestonat-themoney options. Theta only
applies to the amount of the
change in the price of an
option due to time, but the
time value of an option can
change for other reasons. A
decrease in volatility can
cause a loss of time value;
that is measured by Vega. A
change in the underlying
stock price will cause an atthe-moneyoptiontolosetime
value, and that is measured
byDelta.Eveneventssuchas
a change in risk-free interest
rates can cause a decrease in
the time value of an option,
whichiscommonlymeasured
asRho.
Any one of those scenarios
would not only result in a
changeintimevalue,butalso
the rate of time decay. When
factors other than time lower
the time value of an option,
Thetawillalsodecrease.Just
asanexample,ifyoubuyan
at-the-money Call and it
suddenly goes in-the-money,
itwilllosetimevalue,butits
actual price may increase if
theincreaseinintrinsicvalue
isenoughtooffsetthedropin
timevalue.However,because
the time value of the Call is
lower when it is in-themoney, Theta will decrease,
soyouwouldthenexperience
alowerrateoftimedecay.If
you look at deep in-themoneyoptions,manyofthem
havenotimevalueatall;they
often trade at par with the
underlying stock because
Thetaisnearlyzero.Whenan
option has no time value, it
cannotlosevalueduetotime
decay, although it can lose
value for other reasons such
asDelta.
Stock Trader: Theta is
affectedbyfactorsotherthan
time. I’m going to have to
mentally digest that. I think
I’m getting too tired to ask
you to explain that now, but
maybe another day. I think I
am really starting to
understand Theta though.
Now that I know more about
howitworks,Ishouldbeable
to minimize the risk of time
decay when I apply it to my
trend trading. I think it will
helpmeputtogetherasystem
that, as you pointed out,
should give me an 80% win
rate when I am right about
spottingatrend.
OptionzTraderz:Anddon’t
forget to manage risk when
youarewrong.
Stock Trader: Yes, an 80%
winrateisnottheHolyGail,
justawinningtradingsystem.
Optionz Traderz: I prefer
short Theta trading, which is
basicallytheoppositeoftrend
trading.Insteadofafewhuge
wins paying for a bunch of
littlelosses,Ihaveabunchof
small wins and then cut my
few losses short before they
become big. I benefit from
Theta eating up the value of
the options, but I have to
beware of intrinsic value
causingmetolose.
Stock Traderz: That is
different; I do not know if it
fits my personality. All day
while I was at work, I was
thinkingthatsellingtimewas
going to be the path to my
success with options. But
now,IthinkImightbebetter
off sticking to developing a
systemoftrendtrading.
Optionz Traderz: Just like
in stock trading, you must
find a system you are
comfortable trading and
develop faith in your system.
If understanding Theta helps
youdothat,I’mgladIcould
help.
StockTrader:I’mdefinitely
comfortable trend trading.
Thankstoyou,Inowknowa
lot more about how Theta
works, and that should make
me more comfortable trend
trading with options. Short
Theta trading seems like
tradingperishablegoods;they
have an expiration date on
them. I think I would feel
much less stress buying
Theta.
OptionzTraderz:Itisfunny
thatsomethinkonlytheseller
is at an advantage due to
every option contract having
a time of expiration. They
don’t want to buy options
becausetheyknowtheyhave
toberight,notjustaboutthe
move, but when it takes
place. Obviously, you are
able to see that there is also
value in being a buyer.
Optionsareazerosumgame;
the option seller has to be
right about the stock not
movingtoacertainpriceina
designated time frame; the
buyer has to be right that it
willmovetothatprice.
StockTrader:Inanefficient
market both sides are always
equal at the time the trade is
executed.
Optionz Traderz: Exactly.
Selling Theta is a lot like
selling lottery tickets. You
can make a lot of money
because the odds are in your
favor, but you have to also
pay the winners. Some
traders,likeme,preferselling
the tickets and then buying
them back if they look like a
winner just before the last
lotterynumberiscalled.You
seem more like the type of
trader that would prefer
buying lottery tickets and
selling them if the first few
‘numbers’ in the lottery
drawingmadethemlooklike
aloser.
Stock Trader: Good point.
Wellit’sbeennicetalkingto
you, but it’s getting late and
after
this
afternoon’s
commute,I’mwipedout.
Optionz Traderz: I should
get going soon too. It’s been
nicetalkingoptionswithyou.
GhostofDarvas:Ihopeyou
can answer one more
question before you go.
Should I trade my Darvas
system principles but just
adjustthemtooptions?
Optionz Traderz: I think
options may work for you.
For instance, you may want
to only buy two-month-out
options at-the-money at the
time of a breakout, to keep
thesamebuypointyouwould
have used to purchase the
stock. That would alleviate
the stress of trying to predict
breakouts and minimize
losses due to time decay, but
still capture the full move in
intrinsicvalue.
Ghost of Darvas: Great
advice, as always. Thanks.
Youhaveagoodnight!
Stock Trader: Nice chat,
Optionz, and thanks for the
charts.StockTraderout…
Chapter5
VOLATILITY
ISTHE
OPTION
BUYER’S
FRIENDBUT
THEOPTION
SELLER’S
ENEMY.
(VEGA)
It was Thursday night
andStockTrader’seyeswere
gettingheavierandheavier.It
was 11:10 p.m. and once
againhewasuppasthisusual
bedtime. He was looking at
thechartsofthestocksonhis
watch list. Now he found
himself looking at red
candlestick
after
red
candlestick.
“Yuck!” he thought.
“Thesechartslookterrible!”
Hehadbeenwatching
thesesamechartsintentlyfor
over a month, during what
appeared to be a slow grind
downward. His system had
taken him to cash, as the
stocks on his watch list all
lost their 10-day moving
averages nearly three weeks
earlier.Whilehewaswaiting
for a reversal back above the
10-day, they lost the 20-day
moving
average.
Nevertheless, he had kept
watching intently over the
past week. “The 50-day
would be a chance to enter
longagain,”hethought.That
was often a great place for
support in an overall long
term up-trending market.
Also, if the market leaders
lost support at the 50-day
moving average and had
trouble retaking it a few
times, that would be a major
signofachangeintrendand
the probable beginning of a
bear market. His watch list
would then morph into a list
ofstockstosellshort;nothis
favorite way to trade, but a
waytomakemoneyintough
times.
Oddly enough, he
missed his entries because
both the 50- and 100-day
moving averages were lost
within days. The Dow Jones
IndustrialAveragewaslosing
100 points a day, sometimes
more.
Tonight
was
particularly
interesting
because the S&P 500 index
had closed right on its 200day moving average, the
Nasdaq composite was a few
points above its 200-day
movingaverage,andtheDow
Averagewasasafe50points
above the 200-day moving
average. One of Stock
Trader’s systems had him go
longtheS&P500Indexwhen
it bounced off and headed
back up in price at the 200day, or short the index if it
lost that last critical support
level.Hisholdingswerenow
in cash, waiting for a
direction; it was too soon to
take a position because this
was neither a reversal nor a
lossofsupport.Thepricewas
lying right on the fence,
creatingawaitinggame.
Itwasnow11:30p.m.
andtimeforsleep.
Beep, Beep, Beep,
Beep,Beep,Beep
Itseemedasifhehad
just fallen asleep, but the
alarm clock was now
summoning a tired Stock
Trader to put on his tie and
get to work. The open road
andhisdayjobawaitedhim.
He rolled out of bed,
trulyexhaustedfromhislatenight chart observations. He
sleepily walked to the living
room and clicked on the
television; as always, it was
already tuned to his favorite
financial news station. He
retrievedhislastenergydrink
from the back of his nearly
emptyrefrigeratorandalmost
dropped it when he saw that
the European markets were
downover5%.
“What the…!” came
outofhismouth.
Then he remembered
hewasflat;allhiscapitalwas
safelyincashequivalents,no
stocks. He felt like a bullet
had just whizzed past his
head.
Immediately he was
wide awake. “What is going
on?”hethought.
Commentators talked
about how the leaders in one
Europeannationhadfailedto
passausteritymeasurestoget
morebailoutmoneyfromthe
International Monetary Fund.
They would default, their
bondholderswouldbewiped
out, and companies which
soldinsuranceonthosebonds
wouldlosebillionsofdollars.
This was unexpected news,
an outcome that seemed to
have a low probability just
yesterday, and the markets
werereactingviolentlytothe
news.
“Wow! A socialist
paradise collapsing under the
weight
of
government
regulationandentitlements…
truly shocking,” said Stock
Trader out loud, barely
attempting to restrain the
sarcasminhistoneofvoice.
Hesawaquoteforthe
U.S.Dowfutures.Theywere
also down 5%. “No surprise
there.”
On his commute to
work he kept pondering the
meaning of all of the recent
financial
turmoil.
He
considered himself to be a
technical trader. He had
missed his short entry, so
now what? Was it too late to
short and too early to go
long? That gap down caused
him to miss what he thought
was the ‘meat’ of the move.
Should he open a short
position at the open? That
would be keeping to his
system. Should he use a
trailing stop to exit? These
were not easy decisions to
make; these were strange
circumstances, for sure. He
quickly came to his senses
and decided to watch the
market but not place any
trades.
Years earlier, he had
discovered that one of the
keys to his success was
avoiding emotion. He had
found that he could avoid
emotion if he planned his
trades when the market was
closed, then placed trades
based on his winning system
when the market was open.
Trying to plan a trade while
watching financial news on
television on a day when
markets all over the world
weredown5%,wouldbelike
placing a bet on the Super
Bowl with the score tied and
only two minutes remaining
in the fourth quarter.
Emotions were controlling
the market today, and he
madeadecisiontosticktohis
tradingrules.Hewouldwatch
the market as if it was a
football game, but he would
not place any bets during the
trading day. Tonight, when
the markets were closed, he
could study the recent events
and plan his trading for
tomorrow, hopefully with
some help from Optionz
Traderz.
He was watching the
quote at the open. The Dow
Average opened down 4.5%,
and then fell some more,
down 5.5% at one point.
Thirtyminutesaftertheopen
it rallied, so it was only 4%
down from the previous day.
It was exhausting to watch,
but he did not feel the
adrenaline rush that he knew
other traders were certainly
experiencing. His accounts
were all safely tucked away
in cash – or were they? This
was one of those days the
marketwassodisturbingthat
Stock Trader felt the need to
check all his accounts and
ensurewithoutanydoubtthat
they were all completely in
cash. This was not a normal
functioning market; anything
could
happen.
Other
governmentscouldtakesome
kindofbailoutactionandthat
could lead to a rally, or it
couldbeexposedthatamajor
financial
business
was
defaulting on its debt and
going bankrupt, setting off a
systemic problem in the
financial system. This was
not a market Stock Trader
cared to trade. Truly,
anythingcouldhappen.Butit
was as entertaining to watch
from the sidelines as any
sportchampionshipgame.
Throughoutthedayhe
was drawn to get quotes. He
was fascinated with the price
action. Finally at the end of
the day the market closed
down over 6%; this was a
675-pointhaircutofftheDow
Jones Industrial Average. He
was relieved to find that
indeed all of his long
positionshadbeenclosed.He
was 100% in cash. Days like
today made Stock Trader
cherishhistradingsystem.He
had not made any money
today, but so many people
lost so much money that
breaking even on a day like
this meant he had still fared
betterthanmosttraders.
“Wow!”
Onthedrivehomehe
was very interested to know
how Optionz had done. Did
he have one of his Short
Straddles on? If so, he
certainlymusthavebeenhurt.
Whenhegothome,he
did not even take his shoes
off; he went straight to the
computer. Optionz Traderz
wasonline.
“Great”,hethought.
He did not go to the
Winning Traders group; he
wanted to send him a private
message so as not to open a
tradingwound.
Stock Trader: How are you
doingtoday?
OptionzTraderz:Verywell.
WhataCRAZYDAY,huh?
StockTrader:Iknow,right?
I was right at a crossroads
looking for an entry signal
andsafelyincash.Todaywas
so stressful I had to double
check all my accounts to
ensureIhadnolongpositions
on. I felt almost as though I
had an obsessive-compulsive
disorder.
Optionz Traderz: When
trillions of dollars in value
evaporate, it is good to
doublecheckonthesafetyof
yourhundredsandthousands.
It’s not O.C.D., it’s a sound
trading practice. Trading is
stressful enough without
worrying if you forgot about
alongposition.Ifitgivesyou
peace of mind to double
check your investments on a
crazy day like today, do it!
Today’s trading was unlike
anythingIhaveseeninmany
years. It would be crazy not
to obsess over your positions
on a day like this. And it
wouldbeevenmoreinsaneto
risk leaving them open over
theupcomingweekend.
Stock Trader was
anxious to know what
positions Optionz Traderz
hadonthisday.Thecuriosity
wasdrivinghimcrazy.
StockTraderz:Manypeople
gotreallyhurttoday.
Optionz Traderz: Tell me
aboutit,Ireallyfeelsorryfor
the guy that sold me those
Putstwodaysago;thathasto
hurt. However the guy I
bought the Calls from did
wellaslongastheywerenot
CoveredCalls.Ouch!
StockTradersuddenly
felt a little envious. He was
confident that being 100% in
cash had saved him from
horrible losses. He had
broken even today, while
millions of other traders had
lost big time. He had missed
outonagreatopportunityto
go short because most of the
movehadoccurredovernight.
Even if he had attempted to
goshortinthepre-market,he
would have missed nearly
90%ofthemove.ButOptionz
Traderzactuallymademoney
today? How was that
possible?
Stock Trader: What? You
betbothways?
OptionzTraderz:Yes,some
markets lend themselves to
trading Theta, and others are
best for trading Vega. When
the markets meandered
around slowly last winter, I
made a killing selling Theta;
but with the recent spike in
volatility, it makes much
more sense to capitalize on
Vega.
Stock Trader: I remember
youmentionedVegalasttime
we talked, but it seems
confusing. Volatility is
always changing, so how do
you know when it is best to
focus on Theta and when to
shifttoVega?
OptionzTraderz:Vegaisan
important concept in option
trading. Usually it is not as
important as time-decay or
Theta in my opinion, but
there are occasionally days
like today when volatility
spikes that Vega can not be
ignored. There are no set
rules for capturing profits
from Vega, but I’d be happy
tosharemythoughtsaboutit.
StockTrader: I’dappreciate
it. All day, I thought I was
doingbetterthanmosttraders
by not losing money while
most others were. It would
have been nice to be able to
profit from the rise in
volatility, but I did not know
howtodoit.IthinkIhavea
good understanding of Theta
now, but Vega seems a little
morecomplex.
Optionz Traderz: Vega is
not complex at all; in fact, it
issimplerthanTheta.Vegais
nothing more than the effect
of volatility on option
premiums. When volatility
increases, stock prices make
wild swings up or down or
both. That makes predicting
the price of a stock on some
futuredatemoredifficultthan
it would be if prices were
stable.
Stock Trader: I understand
the basics of volatility. High
volatilitymeansthereisalot
ofuncertaintyinthemarkets;
low volatility means prices
are flat or rising. But I’m
having trouble relating
volatilitytoVega.IthinkifI
understood Vega, I would
have been able to profit
today,justasyoudid.
Optionz Traderz: Well, I
havegoodnews.Thetaisthe
most difficult concept of
option trading. If you were
abletounderstandTheta,you
will have no difficulty
grasping all of the other
‘Greeks,’includingVega.
Stock
Trader:
That’s
reassuring. Theta was not
easy to comprehend, but
when you showed me the
charts that used your tortoise
as an analogy, I understood
completely.
Optionz Traderz: I have
found analogies to be very
useful when it comes to
understanding options, so
here’s another one for you.
Thehomeowner’sassociation
formycondoforbidscatsand
dogs–that’swhyIhaveapet
tortoise.Someotherresidents
have pet birds, lizards, even
snakes. But there is an older
lady that lives on the other
side of the complex and she
has a pet rabbit. I think her
rabbit may help you
understandVega.
Stock Trader: I guess I
shouldn’tbesurprised.Ifyou
were able to use a tortoise to
explain Theta, then I won’t
question your use of a rabbit
toexplainVega.
Optionz Traderz: That’s
good to know. Sometimes I
think my analogies are so
crazy that my tortoise is the
only one who will listen to
them, but I really enjoy
sharing them with you. It’s
nice to have a real person
interested in my ideas about
optionsforachange.
Stock Trader: It’s great to
have met someone like you
that can explain options in
such detail. But I feel like I
oweyousomethingforallof
your insight. If this
conversation was in person
instead of on Facebook I’d
offer you a beer for your
thoughts.
Optionz Traderz: Well,
thanks for the offer, but I’d
really prefer a margarita
instead.
Stock Trader: As expensive
as a margarita might be, it
wouldbewellworththecost,
given the advice you have
given me about options so
far. I am really intrigued by
your analogy of Vega and
yourneighbor’srabbit.
OptionzTraderz:O.K.,here
goes: My neighbor takes her
morbidlyobeserabbitoutfor
walks, just like I do with my
tortoise; he likes to eat the
grass and weeds by the pool
too. But as big as he is, he
moves much faster than my
tortoise. I can’t count the
numberoftimeswehavehad
toformsearchpartiestolook
for her rabbit when it
wandered away, while my
tortoisehasonlygottenaway
once.
Stock Trader: So are you
saying that the rabbit
representsVega?
Optionz Traderz: Well, it
represents higher volatility
than a tortoise. Implied
Volatility in stocks is quite
simply the predicted ‘speed’
thattheywillchangeinprice.
I think I have another chart
thatmayhelpyouunderstand.
StockTrader:Thatwouldbe
great. Your charts have been
veryhelpful.
Thesearchareafortherabbitisabout
25timesthesizeofthesearchareafor
thetortoise,representingtheincreased
uncertaintyofthelocationofastock
pricewithhighervolatility.
Optionz Traderz: As you
can see from the chart, the
search area is exponentially
larger for the rabbit.
However, when trading
stocks, it is not the search
areathatisofconcern,butthe
distance of the price from its
startingpoint.Therabbitmay
coveramuchlargerareathan
the tortoise, but its distance
from the starting point is
equal to the radius of the
circle. On average, the rabbit
will be about five times
furtherawaythanthetortoise.
It works the same way with
stocks. A stock with an
Implied Volatility of 50%
will generally move five
timesthedistanceofonewith
an I.V. of 10%, over a set
period of time. The result is
thatthetimepremiumsonthe
high volatility ‘rabbit’ stock
would be about five times as
high as those on the low
volatility‘turtle’stock.
Stock Trader: I think I see
whereyouaregoingwiththis
now. If I buy at-the-money
Call options on one of the
stocks on my watch list, and
volatility suddenly doubles,
the time premium should
double too, even if the
underlying price remains
unchanged.
Optionz Traderz: You’ve
gotit,exactly!That’sallthere
is to understanding Vega; no
complicated formulas. Vega
is simply the change in the
time premium of an option
due to a change in volatility.
And you are correct that an
at-the-money option could
double in price if volatility
doubled. I have two more
charts to send you. I think
they might help you see
exactly how volatility affects
premiums.
Direxion Financial Select Sector
SPDR(ETF)NYSE:XLF
LastTrade12.73
OptionsExpiringSeptember17,2011
Thepremiumtoopenastraddleatthe
$13.00strike(at-the-money)onXLF
isabout$1.12,soonewouldexpectthe
premiumtobeapproximatelythree
timesthatamount,or$3.36,if
volatilitytripled.
Direxion Daily Financial Bull 3x
Shares(ETF)NYSE:FAS
LastTrade13.85
OptionsExpiringSeptember17,2011
Thepremiumtoopenastraddleonthe
$14.00 strike (at-the-money) options
on FAS is about $3.12, roughly three
times the premium to open a straddle
on XLF, because the ETF is tripleleveraged, causing its share price to
moveatthreetimesthespeedofXLF.
Implied volatility on FAS is
approximatelythreetimesthatofXLF.
Stock Trader: That is a
really good example. I knew
volatility affected option
premiums, but I never
imagined it would be so
simple. I used to struggle to
understand the equations in
the Black-Scholes pricing
model, but this makes it so
much easier. If volatility
triples,thepremiumstriple;if
volatility drops 10%, option
premiums fall by 10%.
Thanksforclearingthisup.
Optionz Traderz: You’re
welcome.IthinkI’lltakeyou
up on that offer to buy me a
margarita
now .
But
seriously, you need to
remember that the effect of
volatility, or Vega, only
appliestothetimevalueofan
option. Vega does not affect
intrinsicvalue.Anoptionthat
is deep in-the-money or outof-the-money always has
much lower time value than
anat-the-moneycontract,and
therefore it is affected much
lessbyVega.
Stock Trader: That makes
sense. Increasing volatility
would make it more difficult
topredictthefuturepriceofa
stock,butiftheoptionisdeep
in-the-money,there’sapretty
good probability that it will
staythere,soitismucheasier
topredictitsoutcomethanan
at-the-money option with 5050 odds of expiring in-themoney. So I guess the effect
of Vega would always be
greatest on at-the-money
options, the ones that are the
mostdifficulttopredict.AmI
right?
Optionz Traderz: Exactly!
It’s sort of like betting on
horsesattheracetrack.Ifyou
bet on a horse with that is
showing 9 to 1 odds of
winning, it’s likely you will
win.Thesamegoesfor1to9
odds;it’sfairtosayyouwill
probablylose.But1to1odds
will drive you crazy. Of
course, taking a 9 to 1 bet
willmakeyoumoney,butnot
much of it; it costs a lot to
place a bet with such great
odds.Thebigmoneyismade
andlostonthe1to1odds.
Optionsarenodifferent.Soit
should come as no surprise
thatat-the-moneyoptions,the
ones with 1 to 1, or 50-50
odds, are the most heavily
traded; that is where the
biggest potential profits are.
Mostanythingthataffectsthe
price of an option, such as
time to expiration or
volatility, will have a more
pronounced effect on at-themoney options. When it’s
starts to rain during a horse
race, it’s not the guy who
chose the 9-to-1 bet that is
sweating bullets; it’s the one
with the 1-to-1 bet who is
unsure whether his pick is a
‘mudder.’
Stock Trader: That is
anothergreatanalogy.Iguess
the good news is that in the
options market there is no
racetrack to take a cut of the
winnings. With options, the
winners always walk away
withthesameamountofcash
that the losers have lost. I
wonderifallthoseguysdown
at the racetrack understand
how much better their odds
would be if they started
betting on stock options
insteadofracehorses.
Optionz Traderz: That’s a
good question. I doubt many
of them would make the
switch. Betting on horses is
more emotional than options,
inmyopinion.Ithinkmostof
them do it for the adrenaline
rush.
Stock Trader: You’re
probably right. Most of them
would be bored to death
trading options, even if they
did end up with more money
intheirpocket.
Optionz Traderz: You hit
the nail on the head.
Racetracks are great places
for
emotion
and
entertainment,buttheyareno
place to earn a living, except
for a few lucky folks. When
youtradeoptions,thereisno
racetrack to take a cut of the
winnings, and that is
definitely good news. Now,
here’ssomemoregoodnews.
The majority of the time,
Implied Volatility increases
when prices fall to lower
levels. That means if your
trend trading system led you
to buy a Call, and the
underlying price suddenly
dropped, the time premium
on the Call might actually
increase due to Vega.
Sometimes the increase is
enough to offset much of the
loss of time value due to
Delta. Fear increases Put
premiums more than greed
increasesCallpremiums.
StockTrader:That’sagood
point. If I am going to trend
trade using options, Vega
could help me cut my losses
when I am incorrect
predicting the direction of a
trend. I guess it would also
work with Puts. If I bought
Puts to protect one of my
long stock positions, Vega
could help amplify the
increase in their value in the
caseofavolatiledownturn.
Optionz Traderz: Yes, and
therearemanyotherwaysto
trade Vega. When volatility
spikes way up like it did this
week, I usually like to sell
Naked Calls. The premiums
are very generous now and
prices are continuing to fall.
Of course, I’m not really
sellingVegabecauseVegais
merely a measure of
volatility’s effect on option
premiums.Iamreallyselling
Theta, but taking advantage
of the increase in premiums
and the subsequent increase
in the rate of time decay due
to Vega. However, in my
opinion,thecurrentmarketis
muchtoovolatiletotakerisks
with Theta. Yes, the
premiums are much higher
than they were just a few
daysago,buttherisksarejust
toobig,evenformytaste.
I prefer betting on volatility
instead. I have been playing
Long Strangles in the SPY,
and also Long Calls on the
ETF pair FAS/FAZ. When
the prices move violently,
like they have done recently,
I can profit nicely from the
Strangle on SPY. I can also
profit from the Calls on one
side of the FAS/FAZ pair
going deep in-the-money
soonafterIopenit,whilethe
Calls on the other side
maintain much of their time
value. This method works
best in either volatile or
sharplytrendingmarkets,and
I prefer to use front month
options. When you buy outof-the-money Strangles your
primary risk is Theta decay,
whileyoucapturemoveswith
intrinsic value and increasing
Delta. However, you need a
sharpmove,quickly,andPuts
get more expensive in a
volatile market that is
trending downward. So you
do have the Vega risk; if
volatility collapses it could
causethevalueofyourLong
Strangle to collapse along
withit.Usually,whentrading
Straddles
or
Strangles,
increased volatility is the
option buyer’s friend and the
optionseller’senemy.
Stock Trader: I don’t want
to sound critical of your
trading system, but why
would you have used a
Strangle when you could
havejustboughtPuts?
Optionz Traderz: My
trading is mainly technical. I
really did not know if we
would get a breakout to the
downside or a sharp reversal
upwards if the European
Unionputtogethersomekind
of a rescue. Nowadays,
governments
seem
to
constantly interfere with
trends. So I have been
opening
Straddles
and
Strangles, three-weeks-out,
over the past few weeks, and
planned to close them out on
sharp moves. Today was one
of those moves. I did very
well; my Put side increased
dramatically more than my
Callsidelost.Itincreasednot
onlyinintrinsicvalue,asmy
right to put a price on
someone became much more
valuable because of the
increase in probability that it
would retain that value at
expiration (Delta), but also
because the insurance it
provided became much more
expensive due to the
increased volatility of the
market(Vega).
StockTrader: So this was a
non-directionaltradeandyou
made money. You did not
predictanydirectionjustthat
the market would soon trend
sharply?
Optionz Traderz: Yes and
no.Iwasnotbettingsomuch
thatitwouldtrend,justthatit
would be volatile. I closed
mypositionstodayforahefty
profit and opened a new
Strangle at-the-money again.
Ialsodidthisafewdaysago
when the market gapped up
huge at the open, amid
rumorsofanensuingbailout.
ThatmorningIclosedoutmy
LongStrangleintheSPYfor
a nice profit, then opened
another and made an
additional profit when the
marketlosttheearlymorning
gains and collapsed in price
before noon. It got a little
ridiculous, like I was a day
trader
using
volatilitypumping to make money. I
usually expect one large
move a week to make me
profitable, not two in one
morning!
StockTrader:I’mnotsureI
understand. Why didn’t you
justletyourprofitsrun?That
iswhatIwouldhavedone.
Optionz Traderz: With
volatility increasing each day
and intra-day moves of over
200 points in the Dow, I just
donotfeelcomfortablewitha
directional trade. When my
Putsidewentmanystrikesinthe-money,itwasnolongera
Straddle; it was a Long Put
with intrinsic value, while at
the same time a Long low
probability Call. I wanted to
take my money off the table
whileitwasthere.Iwantedto
get Delta neutral again and
only be long Theta in this
market.
StockTrader:Inmystyleof
trading I would have let my
profitsrunonthePutsideand
closedmyCalls.
Optionz Traderz: That is a
viableplanforatrendtrader.
I personally can’t stomach a
trend trade in this kind of
market. The average daily
range is just so wide. I feel
more comfortable risking
Theta in this environment,
and I have learned that my
comfortwithmytradesisthe
mainkeytomysuccess.
Stock Trader: Yes, sweaty
palms do not make for good
tradingdecisions.
Optionz Traderz: Neither
due wildly swinging, volatile
prices.
Many
times
volatility=stress=panic. What
better way to capitalize on
volatilitythantoopenaLong
Strangle or Straddle and sit
back and watch the show,
with only Theta and Vega as
risks? I am risking a small
amountofmyequityandwill
profit in either direction as
long as there is a strong
move.
Stock Trader: I get it,
thoughIwouldprobablyhave
let it run its course and
watched which direction the
trend finally went for really
bigprofits.
Optionz Traderz: That is
alsoavalidsystemandcould
make you some serious
money. I trade, though, for
livingexpenses,notlongterm
capitalappreciation,soItend
to take profits quicker than a
trend trader who is looking
for homeruns. I am happy
with a high batting average
and getting runs batted in to
homeplate.
StockTrader:Wow,youare
just full of analogies today.
But that makes sense. I also
wanttotradeforalivingone
day soon. So let me see if I
fully get the Long Straddle
and
Strangle
concept
completely. The market is
getting volatile; the daily
ranges for the main indexes
are getting wider and wider.
We are in a general march
downward in prices, but not
without some big up days in
between. A long straddle
would be like going to two
tradersandmakinganoffer.
Tothefirstbearishtraderyou
say,
“The Dow is at
11,000.Iwillpayyou$2,000
but you have to pay me the
full move the Dow moves
above 11,000 on $110,000
worth of the Dow Diamonds
Exchange Traded Fund,
‘DIA’, over the next four
weeks;howeveryoucankeep
the $2,000, just pay me my
profits.” This would be like
10 Long DIA Call contracts,
or1000shares.
To the second trader, who is
bullish,yousay,
“The Dow is at
11,000.Iwillpayyou$2,000
but you have to pay me the
full move the Dow makes
below 11,000 on $110,000
worth of the Dow Diamonds
Exchange Traded Fund,
‘DIA’ over the next four
weeks;howeveryoucankeep
the $2,000, just pay me my
profits.” This would be like
10 Long DIA Put contracts,
or1000shares.
The beauty of this trade is
thatonadayliketoday,when
theDowmovesover6%,the
personwhosoldyouthePuts
issweatingbulletsbecausehe
owes you $6,600 in intrinsic
value in one day, plus time
value, so it could cost him
over $7,500 to buy back his
Short Puts from you. At the
same time, the guy that sold
you the Calls is pretty happy
he may have made $1,500
andwouldprobablybehappy
to by back the Calls he sold
youyesterdayfor$2,000,ata
fire-salepriceof$500.Allin
all,youwouldlose$1,500on
the Calls but earn $5,500 on
the Puts. That amounts to a
$4,000 profit or the
equivalent of a 100% return
on capital in one day.
However,closingthetradeis
not mandatory because you
wouldhavethechoicetoletit
runitscourseandown100%
ofthedownsidetrendforthe
remainder of the month,
which could further increase
your profits. You have the
choice of taking your profit
while it is ‘on the table’ or
lettingthebetplayoutforthe
restofthemonthtomaximize
itspotential.Inthemeantime,
you are allowing two other
traders,thesellersoftheDIA
options,totakealotofriskin
avolatilemarket.Butyoucan
feelconfidentwhenyouopen
a Long Straddle that you are
the most likely to come out
ahead because in a volatile
market the losing seller
usually loses more than the
winningsellerwins.
Optionz Traderz: I believe
you have it, although I have
tosaythatwasauniqueway
of explaining it. It really is a
great way to profit from
volatility,nottomentionhow
it gives me defined risks on
mylongoptions,soIcontrol
mylossesandmyriskofruin
inawildmarket.Also,froma
psychological perspective, I
have very little stress during
troubledtimes,soIsleeplike
a baby at night while other
traders are up all night
watching all the world’s
markets and the future’s
markets, attempting to read
the next market direction.
Whatabigwasteoftimethat
is! In my opinion, trading
options eliminates a lot of
that waste. I sometimes use
optionsontheiPathS&P500
VIX Short Term Exchange
Traded Note, VXX to profit
from
volatility.
When
volatility is low, far out-ofthe-money Calls on VXX
sometimes cost only pennies,
but they can be huge profit
makerswhenthemarketgoes
berserk like today. Some of
my Calls on VXX had a
300% return today, despite
thefactthattheyarestillout-
of-the-money. I closed them
this afternoon and took my
profits while they were there
and decided not to open new
Calls because Vega has
caused the premiums to get
toohighformycomfort.
StockTrader:Imustadmit
thatIamveryimpressedwith
your option trading prowess
inthismarket.Youmusthave
different systems in different
markets?
Optionz Traderz: I have a
garage full of different
vehiclesfordifferentterrains.
StockTrader:Huh?
Optionz Traderz: I don’t
takeaFerrariout4-wheeling,
so I don’t sell close-to-themoney Naked Puts in a
market that is collapsing in
price.
In a flat market, I sell short
Straddlesat-the-money.
In a range bound market, I
sell Short Strangles, with
Calls above resistance and
Putsbelowsupport.
Inaragingbullmarket,Ibuy
Calls on hot stocks and sell
NakedPuts.
Inabearmarket,IbuyPuts.
In a wildly volatile, 400
points up today 500 points
down tomorrow, roller
coaster market I buy long
StraddlesandStrangles.
Stock Trader: So the moral
of the vehicle analogy is
don’t trade the wrong option
strategyinthewrongmarket?
I guess that must be one of
the most important rules for
an option trader: use the
strategy that is best suited to
thecurrentmarketconditions.
But when do you bring out
thepinkCadillac?
Optionz
Traderz:
On
Saturdaynight.
Stock Trader was
feeling a new sense of
confidencethathewouldone
day be able to trade options
as a means of financial
independence.
Optionz
Traderz seemed to make
trading stock options appear
to be simpler than he ever
imagined. Previously, Stock
Trader had found that time
decay and Theta were
difficult to understand, but
Optionzmadeitsoeasywhen
he changed it into a simple
equationrelatedtothesquare
root of time. Then he had
shown how volatility and
Vega are even easier to
understand, affecting option
premiums
without
any
complex equations at all. All
those days he had spent
researching
the
BlackScholes
pricing
model
suddenlyseemedlikeawaste
oftime.“IwonderifOptionz
is correct about all the other
Greeks being this easy; what
about Delta and Gamma,
couldtheybesimpletoo?”he
thought.
Itwasgettinglateand
there was another grueling
day of work ahead, so Stock
Trader decided to wait until
the next evening to find the
answers. But he would
definitely have to inquire
aboutDeltathenexttimethey
talked. Maybe now that he
knew how Theta and Vega
worked,agraspofDeltawas
allthatremainedtosatisfyhis
desire to trade options for a
living. As tempting as it was
toaskforanswersnow,Stock
Trader’sstomachwasempty,
his eyelids were getting
heavier,andheslowlydrifted
off to sleep in his chair in
frontofthecomputer.
Chapter6
DELTA:HOW
MUCHOFTHE
MOVEDOYOU
GETFORTHE
MONEY?
Stock Trader slowly
opened his eyes and
discovered that he was still
sittinginhiscomputerchair.
“Good grief, where
amI?Whatdayisit?”
It was still dark; his
computer was in sleep mode,
just like he had been. He
clickedthemousetobringthe
monitor back up and he
lookedtoseethatitwas3:21
in the morning and it was
Saturday.
He loved Saturday
because he was paroled from
hiscubicleonthatday,butat
the same time he was a little
sad that the markets would
not be open, as they had
become his major source of
entertainment.
Almost immediately,
thoughts of Vega and Theta
began to float through his
mind. He started pondering
how these option variables
wouldaffecthistrading.Such
dynamics did not exist in
stocks. With a stock, what
you see is what you get, but
with options he owned dated
contracts.
With options he had
to be right about a stock's
movement
within
a
timeframe, and changes in
volatilitycouldalsohelphim
orhurthiminhistrading.
He looked down
casually at the time and saw
thatitwasnow4a.m.
“My name is Stock
Trader and I am an
‘optionaholic,’” he said out
loud.
He made himself get
up and go to bed, where he
continued to think about
options. He figured he could
risklesspertradebutstillget
most of the movement when
he was right. It was possible
thathecouldlosecapitalata
faster pace than with stocks
but greatly limit his losses
with a clearly defined
downside. He figured an
option contract has a built-in
stop loss due to much less
capital needed to buy a
contract;
would
option
trading prove to be more
protectivethanastoplosson
a stock’s price? Stop losses
on stocks do not protect
traders from aftermarket and
pre-market gaps in price.
Withthewaythemarketwas
currently moving he did not
feel confident in the
protection of a traditional
stop loss. Stop losses were
ineffective on gaps on the
open in the wrong direction.
When the broader market
moved over 4% and
individual stocks were being
hammered with up to 10%
lossesinonetradingday,and
with the majority of those
moves happening with gaps
down at the open, Stock
Trader was beginning to feel
more comfortable with
smaller option positions than
larger stock positions. This
wastrulyacrazymarket.
“While long options
may not protect me
completely, they do limit the
losses to the price of the
contract which is far less
capitalatrisk,”hethought.
Stock Trader started
to envision how when he
bought contracts, the seller
took on much more risk than
he did. He liked that. The
seller would benefit from
time decay; he would benefit
fromafavorablemoveinthe
rightdirection.Asabuyerhe
would benefit from an
increase in market volatility
whilethesellerwouldbenefit
fromacollapseinvolatility.
He started to believe
that the option buyer might
actually have an advantage
through actual capital at risk.
Buthewasunsureofwhether
he was correct, and his
thoughts went back to
OptionzTraderzsayingitwas
azerosumgameandtherisk
to the seller was reflected in
the premium. He had read
conflicting studies, some
showing 30% of options
expiring worthless, others
indicating that the rate was
closer to 80%. Whatever the
actual rate, he felt reassured
by
Optionz
Traderz'
philosophy that the winner’s
winnings, whatever their
percentage might be, would
beoffsetbytheloser’slosses
inthelongrun.Still,although
he couldn’t put his finger on
it,therewassomethingabout
sellingoptionsthatmadehim
feel uneasy. He felt much
more
comfortable
contemplating option trading
asabuyer.Iftherewasaway
to keep option trading in his
comfort zone, it would
greatly increase his chances
for sticking with a winning
systemandultimatelyleadto
his success. Thanks to
Optionz, he was now much
more comfortable with the
concepts of Theta and Vega,
but what about the other
Greeks?
His
thoughts
wondered to Delta. This was
interesting. If options had no
valuewhentheyexpired,they
wereworthless.Heneededto
fully understand how Delta
functioned to help in his
trading.Hecouldnotjustflip
hisstocktradingsystemsover
to option trading and expect
the same returns. He figured
it would be like applying the
rulesforcheckersintoachess
game and wondering why he
had lost. He had to fully
understand what he was
doing BEFORE he started
tradingoptions.Hewantedto
learn about options without
having to pay higher than
needed‘tuitions’intheoption
markets themselves, with
losses he might not yet even
contemplate. He felt he had
already paid his full tuition,
sufferingsubstantiallossesas
a stock trader before
eventually
finding
a
successfultradingsystem.He
wanted to avoid those initial
losses this time. If he was
going to convert his stock
trading system to option
trading, he would do it the
rightway.
He knew that soldiers
did not go into combat
without full military training
andhewouldbenodifferent.
He would understand options
before he traded them.
Luckily he had his own
personal option sergeant
running a very friendly boot
camp.
Heneededtocontinue
hiseducationinoptions.
He picked up his
smartphoneandlookedatthe
time;itwasnow8a.m.
“Would Optionz be
online this
wondered.
early?”
he
There was only one
waytofindoutforsure.
He went back to his
computer and sat in his desk
chair. He looked on his
favorite social media site for
goodnews.
Online
OptionzTraderz
Friends:
Bingo!
Stock Trader chose a
direct chat, instead of the
groupsetting,toavoidallthe
annoyance involved with
ignorant know-it-all traders
and those relentless penny
stockpumpers.
Stock Trader: You are up
earlythismorning.
Optionz Traderz: I guess
mysleepingpatternisgeared
withthemarkets.
Stock Trader: I have been
thinking about transitioning
my stock trading to option
trading and wondered what
yourthoughtswereaboutthe
best way to do this without
actually
getting
worse
performance
by
not
considering the Greeks
correctly.
Optionz Traderz: That is a
great question. There are
manyfactorsyouwillwantto
consider.First,youwillhave
to make your options match
your
timeframe.
You
shouldn’t trade weekly
options if you plan on your
trade working over two
months;atthesametimeitis
not usually a good idea to
day-trade
two-month-out
options.Justtoillustratehow
important matching your
optionstoyourtimeframecan
be, consider this: A buy-andhold stock trader who
attempts to protect his trade
using monthly Puts would
pay about three times as
much in combined premiums
overthecourseofoneyearas
he would buying one set of
Putsexpiringinayear.
Stock Trader: That makes
perfect sense. If one of the
stocks on my watch list
usually had breakouts that
only lasted a few weeks, I
would be wasting money
payingtheincreasedpremium
on two-month-out Calls.
What do you think are the
main variables to consider in
converting my trend trading
systemovertousingoptions?
Optionz Traderz: In my
opinion, Theta is the most
important
concept
to
understand when converting
tooptions.Unlessyouhavea
streak of incredibly good
luck, you will not make a
profit unless you understand
how time affects options.
NextisVega,becauseevenif
you understand time decay,
you don’t want to be
surprisedbyvolatility’seffect
on
options.
Without
consideringVega,yourunthe
riskofpayingoverlyinflated
premiums during periods of
high volatility. Or you might
find
yourself
closing
otherwise profitable trades if
volatilitycausedyouroptions
tomoveinawaythatyoudid
not expect. Time and
volatility are really the only
two major things that affect
the price of options. If you
can comprehend those two
concepts, then you are well
on your way to being
successful. But if you are
going to adapt your stock
trading system to options,
Delta might prove to be the
mostimportantconceptofall
foryou.
Stock Trader: I definitely
wouldn’t consider myself an
expert when it comes to the
Greeks, but I think I have a
basic understanding of Delta.
FromwhatIhaveread,Delta
causes the price of an option
to move up or down at a
fraction of the price
movement of the underlying
stock.Ifastockpricegoesup
by $2.00 and I own a Call
option with a Delta of 0.50,
wouldn’tDeltacausemyCall
togoupinvalueby$1.00?
Optionz Traderz: Yes and
no. Unlike Theta and Vega,
Delta does not have any
direct effect on option
premiums; it is simply a
measure of the observed
effects of time and volatility
astheunderlyingpricemoves
upordown.
StockTrader:I’mnotsureI
understand. If time and
volatility are the only factors
that determine option prices
and Delta has no effect, why
wouldunderstandingDeltabe
moreimportantthanThetaor
Vega?
OptionzTraderz: Theta and
Vega are the two most
important factors of several
that go into option pricing,
andalthoughDeltaisnotone
ofthosefactors,IthinkIcan
explain why it still might be
themostimportant.
Stock Trader: Oh, great,
here we go with another
tortoisestory.
Optionz Traderz: LOL!
Sorry to disappoint you, but
no tortoise and rabbit
analogies this time. I hope
theyhelpedyougainabetter
understanding of Theta and
Vegathough.
Stock Trader: They were
veryhelpful.Sowhatdoyou
have in mind this time, lions
andtigersandbears?
Optionz Traderz: Not
exactly. Even with as much
success as I have had with
options, I wouldn’t consider
myself to be the Wizard of
Options.That’sfunnythough.
So here goes. You already
knowhowtimeandvolatility
affect options. Risk-free
interest rates also have an
effect. When interest rates
rise, rather than risk money
on stocks, traders can put
much of their money in a
risk-free account, then use a
much smaller amount to buy
Calls.Thatdrivesupdemand
forCalloptions,whichcauses
premiums to rise slightly,
whichismeasuredbyRho.In
my experience, the effect of
Rho is so small, especially
when trading options only a
month or two before
expiration, that it can
generallybeignored.
Stock Trader: That’s good
toknow.IfIcanignoreRho,
it is one less thing to think
about.
Optionz Traderz: I agree.
The less you have to think
about,themoreyoucanfocus
onthepartsofoptionswhich
arethemostimportant.There
are a dozen or so additional
Greeksthatinmyopinioncan
also be ignored. There are
Greeks
that
measure
everything from the ‘charm’
ofanoptiontoits‘color’;but
it has been my experience
thatDeltaisthekeytooption
tradingsuccess.
Stock
Trader:
That’s
interesting. I believe that is
similar to stock trading.
When I clutter a chart with a
dozen technical indicators, it
does nothing but take my
attention away from the
moving averages and volume
indicatorswhichIhavefound
to be the most useful in my
trend
trading
system.
However when I focus on a
fewkeyindicators,itismuch
easierformetospotatrend.
Optionz Traderz: I’m glad
you agree. With that said,
there are a couple of factors
thatarenotGreekswhichyou
shouldn’tignore;oneofthose
is
ex-dividend
dates.
Dividends are like unwanted
pests to an option trader.
When a company announces
an upcoming dividend, the
priceofCallsdecreaseswhile
the price of Puts increase to
compensate for the expected
drop in price on the exdividend date. It normally
does not have a huge effect
onpremiums,butyoushould
atleastbeawareofit.Also,if
youownCallsonastockthat
is about to go ex-dividend,
youmightconsiderexercising
them early even if they are
out-of-the-money if you
expect the dividend to
outweigh the loss of the
remaining time premium.
Conversely,ifyouhaveShort
Calls on a stock nearing exdividend, you should pay
close attention to your
account because there is an
increased risk of early
assignment,notonlyonCalls
that are in-the-money, but
also those that are slightly
out-of-the-money.
StockTrader:Wow!Inever
thought of that, but it makes
sense. If I owned a Call that
was 10 cents out-of themoney and was so close to
expiration that the bid price
was 25 cents, it might be
profitable to exercise it early
ifthedividendwasenoughto
offsetthecombinedlossof35
cents. But if the stock price
usually falls on the exdividenddate,wouldn’tIjust
be setting myself up for a
loss?
Optionz Traderz: Not
necessarily. Stock prices are
dependent not only on the
assets and obligations of the
company, but on the
expectation
of
future
earnings. A dividend creates
an additional obligation for
the company, but it normally
does not affect future
earnings.Theresultisthatall
other market forces being
equal,thepriceofastockwill
normally fall by only a
fraction of the amount of the
dividend, most often in the
pre-markethoursonthedayit
goes ex-dividend. So using
your example, if the stock
consistently paid a dividend
of $1.00, and the price
historically dropped 50 cents
the morning of ex-dividend,
that would still be more than
enoughtooffsetyour35-cent
loss.
StockTrader:Ineverwould
have thought to exercise an
out-of the-money option and
certainly would never have
expected to get assigned an
out-of-the-money Short Call.
That’s something I will
definitely consider from now
on. So now I think I have a
pretty good understanding of
ThetaandVega.Iwillignore
Rho, and I will pay close
attention to my options
aroundex-dividenddates.But
I’mnotsureIunderstandhow
this is all going to tie in to
Delta.
Optionz Traderz: O.K. I’m
getting there. But first, there
isonefinalfactoryoushould
watch: liquidity. Liquidity is
often more important than
Theta, Vega, Rho, and
dividends combined. As I
often like to remind option
traders, it has been my
experience that every option
strategy left unmanaged will
eventuallyreverttothemean,
andgivenasufficientnumber
of trades will break even. I
attribute most of my success
with options to be the result
of managing my trades.
Management is different for
every trader, but it might
requiretakingyourmoneyoff
thetablewhenitisthere,orit
could involve closing your
losing trades quickly while
letting the winners run. It
could also employ tactics
such as rolling options to a
different strike or a different
expirationwhenthetradegets
too risky. Whatever the
means undertaken to manage
the trades, it will almost
certainly become necessary,
at least occasionally, to open
or close positions. Doing so
with options that don’t have
sufficientliquidity,thosewith
largespreadsbetweenthebid
priceandtheaskprice,could
quicklyleadtoruin.
Stock Trader: I think I see
what you’re saying. If I buy
Calls at the ask price with a
bid/ask spread of 50 cents,
even if I am correct in
predicting a trend and the
premium rises by 50 cents, I
would probably only break
evenifIsoldthematthebid
price.
Optionz Traderz: Exactly,
andifyouonlybreakevenon
your winners, how are you
going to offset your losing
trades?
StockTrader:That’sagood
question. I guess the answer
is to stick with options that
havegoodliquidity.
Optionz Traderz: Oh, yes,
liquidity is a big deal with
options. Like we have talked
about before, you have to be
more selective about which
options you trade when you
convert from stocks to
options. Options do not have
the depth of liquidity that
moststockshave.Evenifyou
tradethemostliquidoptions,
they have wider spreads,
especially at strike prices
fartherawayfromthecurrent
price or expirations farther
out in time than the current
month.
Stock Trader: So while I
benefit from leverage with
options, I am at a
disadvantage with liquidity if
I get too far off the current
beatenpath.
Optionz Traderz: Exactly,
the stocks and ETFs on your
option trading watch list will
probably be much shorter
thanyourstocktradingwatch
list.
StockTrader: I guess I will
needtotradeinthe‘bigriver’
options and stay out of the
‘smalloptioncreeks.’
Optionz Traderz: Yes,
generallyitcoststoomuchto
jump in and swim in the
smallcreeksandthenmoreto
getout.
Stock Trader: I guess I
could lose my shirt
swimminginthesmalloption
streams.
Optionz Traderz: LOL.
O.K.,nowforthefinalpartof
the equation: Delta. If you
always hold your option
positions until expiration,
there is no need to consider
Delta. Delta disappears on
expirationday,soeitheryour
position will expire with
intrinsic value or it won’t.
But I’m sure you see the
value in managing your
option positions to enhance
your long term profits. Even
if you are able to avoid the
pitfalls of reduced liquidity,
you will eventually find it
necessarytocloseorrollyour
positions before expiration,
either to increase profits,
reduce losses, or both. You
could use complex formulas
involving time decay and
volatility to calculate the
expected results of those
required trades, but Delta
combineseverythingintoone
simple formula. When you
haveanopenoptionposition,
Delta is your most important
indicator.Likeaspeedometer
in a car, it tells you your
option
price’s
velocity
relative to the underlying
stock. But just as a car’s
speedometer does not control
the car’s speed, Delta does
not control the price of your
options.
Stock Trader: Delta shows
me the amount of money I
willwinorlosebasedonthe
combinedeffectsofeachand
every factor that determines
thepriceofanoption.Soit’s
like a summary of all of the
Greeks?
Optionz Traderz: Exactly.
Just like driving a car, you
would go insane trying to
calculate all the different
variables that affect your
speed – the amount of
pressure you are applying to
the accelerator pedal, the
uphill or downhill grade of
the
pavement,
wind
resistance, tire pressure, etc.
It is so much easier to just
lookatthespeedometer.
StockTrader:That’sagood
point. So if Delta is like a
speedometerforoptions,how
would I apply it to a system
oftrendtrading?
Optionz Traderz: Well,
there are two ways you can
use it. Profitability from
trading options, as with any
othertypeoftrading,requires
eitherincreasingyourprofits,
decreasing your losses, or
both. If you have a proven
system that allows you to
predict trends, you are well
on your way to increasing
profits.Youcouldsimplyuse
your system to help you
choose the best entry point
for an option trade and then
ignoreDeltaandalltheother
Greeks by letting each trade
ride out the entire contract
untilitexpired.Inmostcases,
that would be a valid way to
ensureprofits.Aslongasyou
were accurate about the
directionofatrendmorethan
50% of the time, chances are
youwouldbeprofitableinthe
long run. However, I’m
assuming you are probably
like most trend traders who
do not rely solely on
increased profits for their
success; they also limit their
losses. If you are going to
limityourlosseswithoptions,
Delta should help you
determine not only the most
appropriate option for your
strategy, but also the best
positionforeitherastoploss
oratrailingstop.
Stock Trader: That makes
perfect sense. When I trade
stocks, I often set a stop loss
just
below
resistance.
Sometimes I use a moving
average to determine a
resistanceprice,othertimesI
use a recent low. So how
would you suggest putting
Theta, Vega, and Delta
together to create a winning
system?
OptionzTraderz:Ifyouare
using options to trade a
classical
stock
trading
system, Theta and Vega will
belessofafactormostofthe
time. Your ability to use less
capitaltotradeandwinmore
on a percentage basis when
you are right will be much
more important than time
decay or volatility premium
increasing and decreasing –
well, at least most of time.
Thereofcoursewillbetimes
thatthemarketdoesnotmove
at all and time decay costs
you some capital, as well as
times
when
volatility
collapses and causes the
options you own to fall in
price, but this should be the
minority of the time if you
have a robust system. Theta
and Vega are important
Greeks, but Delta is the one
that will help you make
money.
Stock Trader: That’s good
tohear.SoputtingThetaand
Vega to the side, what are
your thoughts on trading
usingDelta?
Optionz Traderz: Delta is
oftenthemostdifficultpartof
options for new traders to
grasp. Unlike stocks, where
thepricesmoveupanddown
exactly the amount that
market forces are pushing
them, option prices usually
move at a slower rate. When
the price of a stock goes up
by$1,theat-the-moneyCalls
usually increase about 50
centsbecauseDeltaisusually
near .50 with at-the-money
options.
Stock Trader: I’ve always
noticed that at-the-money
Calls increase in price at
about half the rate of the
underlying, but I have never
completely understood the
reasonwhy.
Optionz Traderz: I think I
canexplain,ifyoulike,andI
promise,
no
analogies
involvingpets.
StockTrader:Thatwouldbe
great.
Optionz Traderz: O.K., say
youbuyanat-the-moneyCall
for $1.00 and the stock price
immediately goes up $1.00.
Whenyouinitiallyboughtthe
Call, the odds that it would
endupexpiringin-the-money
were 50-50, and that is the
highest possible amount of
uncertainty possible in an
option trade. Later, when the
stock price has risen by
$1.00, the odds are much
greater that the Call will
expirewithintrinsicvalue,inthe-money. The odds are
greater, so there is much less
uncertainty
about
the
outcome at expiration, and
less uncertainty means that
thetimevalueoftheoptionis
much less. So while the
intrinsic value of your Call
would increase by $1.00, the
time value would likely
decreaseby50cents.
Stock Trader: I’ve noticed
that on some of my favorite
stocks,Deltaonat-the-money
Callsislowerthan0.5andon
othersitishigher.Ifthereisa
50% chance of these options
expiring
in-the-money,
shouldn’ttheDeltaalwaysbe
0.5?
Optionz Traderz: That’s a
great observation, and it’s
definitely worth discussing.
ThestrikepriceofaCallwith
a Delta of 0.5 is based upon
oddsbeing50-50thatsuchan
option will be in-the-money
atexpiration.
Stock Trader: I understand
that, but I’m looking at
options on a stock that is
trading at $75. Why would
the Delta on the $75 Calls
onlybe0.44?
Optionz Traderz: Does that
stockpayadividend?
Stock Trader: Let me
look…Yes,thereisa68-cent
dividend and the ex-dividend
dateisnextweek.
OptionzTraderz:Thereyou
haveit.Theoddsarethatthe
stock price will drop slightly
after the ex-dividend date to
reflect the amount of money
that the company will be
obligated to pay out as
dividends to its shareholders.
So the odds of the $75 Calls
expiringin-the-moneyarenot
50-50 because all other
marketforcesaside,thestock
would be trading slightly
lower than $75 after the exdividenddate.Thechancesof
the $75 Calls being in-themoney at expiration are
slightly lower than 50%, due
tothedividend.
Stock Trader: O.K., I can
understand that. Dividends
lowerthelikelihoodofaCall
closing out with intrinsic
value, but why would the atthe-money Calls on one of
my ETFs have a Delta of
0.67?
Optionz Traderz: I think I
canexplainthattoo.Muchof
the time, 0.5 is a good
approximationofDeltaonat-
the-money options, but it is
just that: an approximation.
Volatile stocks and ETFs,
especially those that are
double- or triple-leveraged,
haveatendencytoincreasein
value much faster than they
losevalue.
StockTrader: Sotheat-themoney Delta could be higher
than 0.5 because there is a
greater chance of the price
increasing?
Optionz Traderz: Yes and
no. The odds are the same,
but the outcomes are
different. Consider a volatile
stock that increases in price
20% for three consecutive
months.
Due
to
compounding, the price
would be nearly 73% higher
at the end of the last month.
Now, assume the same stock
declines20%eachmonth.At
theendofthethirdmonth,it
wouldhavelostabout51%of
itsvalue.
Stock Trader: I see. The
extreme volatility would
make the expected gains
much greater than the
expectedlosses.
Optionz Traderz: Exactly.
The underlying shares can
onlylose100%oftheirvalue,
but it is possible they can
increase in value by more
than100%.Mostofthetime,
stocks do not see such wild
swings, so at-the-money
Delta is often very close to
0.5. But on very volatile
stocks and ETFs, Delta is a
reflection of the limited
downside potential and the
unlimited
upside.
The
chances of the underlying
price going up or down are
still 50-50, but the potential
profit or loss from each of
those possibilities is not
equal.
Stock Trader: Now I
understand.Deltaisnotjusta
measure of the odds that an
option will end up in-themoney, but how deep in-themoneyitwillbeatexpiration.
OptionzTraderz:True.Soif
you are buying Calls, you
needtonotonlyconsiderthe
strike price, but also the
Delta.IfyoubuyCallswitha
very low Delta, you won’t
makemuchmoneyunlessthe
underlying shares see large
gains.
Stock Trader: So I guess
whatyouaresayingisthatif
Iuseoptionstotrendtrade,I
should probably buy Calls
with higher Deltas so that I
pick up more of the move of
theunderlying.
OptionzTraderz:Exactly.If
yoursystemhasagoodtrack
record of predicting trends,
thenyouwilllikelydobetter
with in-the-money and
possibly
at-the-money
options because they have
much higher Deltas. There
are times when I use far outof-the-money options in my
trading, but for a trend
tradingsystem,Ithinktheinthe-money ones will work
best for you. When you are
right about a trade you want
to profit, you do not want to
berightandstilllose.
Stock Trader: How is that
possible?WhenItradestocks
and I am right about
predicting a trend I almost
neverlose.
Optionz Traderz: Say your
chartsareindicatingabullish
trend, so you decide to buy
far out-of-the-money Call
optionsbecausetheaskprice
appears very cheap. You
mightbetemptedtothinkyou
aregettingagreatdealonthe
Calls and anticipate a great
returnonyourcapitalatrisk.
You are sure that your stock
will go from $100 to at least
$110 in one month, so you
buyone-month-out$110Call
options. The Delta on your
Call options might be .10.
Whatisnotrealizedbymany
of these other ‘river boat
gambling’tradersisthata.10
Delta means there is only a
10% chance the stock will
make it to $110 in a month.
That is a 10% move in the
stock for goodness sake.
These options are nothing
short of lottery tickets; your
stock might go up to $105
over two weeks and these
optionswouldprobablymove
lessthanadollar.
Stock Trader: Less than a
$1?Butthestockmoved$5.
Optionz Traderz: Your far
out-of-the-money $110 Call
has zero intrinsic value. The
only reason such an option
existsisthatthereisaremote
possibility that it will have
intrinsic value at expiration.
When you buy out-of-themoney options, you do not
capturetheunderlyingstock’s
move in intrinsic value; you
only capture the increased
valueintheoddsthatitcould
be worth something at
expiration. You only capture
Delta,andDeltaisverysmall
when you are so far out-of-
the-money. Also, your old
friends, Theta and Vega,
would likely eat up most or
all of the increase in value
while you were waiting for
themove.
Stock Trader: So if I held
through to expiration and the
stockgotto$109.50,I’dstill
lose100%ofmycapital?
Optionz Traderz: That is
true, however if it did move
that close to the strike price
thentheDeltawouldincrease
becausetheprobabilityofthe
option having intrinsic value
at expiration increased. As
the price move gets closer to
the strike price, your Delta
gains velocity and your
option begins to be worth
more faster. If you exited at
therighttimethatcouldbea
profitable trade. However,
like you said, if you were
convinced that it was not
going to end up expiring in-
the-money and you held it
anyway, you would lose
100%ofyourcapital.
StockTrader:ThatiswhatI
would be tempted to do with
mytrendtradingmethods,let
thewinnersrun;butinoption
trading I would run out of
time.
Optionz Traderz: As you
get near expiration, the
probability value of your
optiondisappearsandyouare
left with Delta value only,
which will increase near
expiration if you are in-themoney. That is good if you
are in-the-money but bad if
youarenot.
Stock Trader: What do you
mean when you say Delta
value
expands
near
expiration?
OptionzTraderz: Just as an
example, a one strike deep
Call option with three weeks
until expiration might have a
.70 Delta because the odds
are70%thatitwillstillbeinthe-money when it expires.
However, the same option
with one week to expiration
may have a .90 Delta,
because the odds that it will
endupexpiringin-the-money
are 90% due to the fact that
thereismuchlesstimeforthe
underlying price to move in
theoppositedirection.
Stock Trader: So Delta
increases as an option nears
expiration, while time value
decreasesatthesametime?
Optionz Traderz: Yes. It
may be helpful to think of
ThetaandVegaasthechange
in the rent being charged for
control of the underlying
stockatthestrikepriceofthe
option.Remember,whenyou
buy options, you are buying
time. When you buy options
based on Delta, it is like
buying the probability of an
option keeping its intrinsic
value or gaining intrinsic
valuebeforeexpiration.
Stock Trader: So are you
saying that in-the-money
options have a higher Delta
thanthosethatareout-of-themoney, so I should focus on
them as a means of
converting my trend trading
fromstockstooptions?
Optionz Traderz: Exactly.
Thedeeperin-the-moneyyou
go, the higher the odds are
that the option will stay inthe-money;soDeltaincreases
as you go deeper in-themoney and decreases as you
go further out-of-the-money.
ThereisanotherGreek,called
Gamma, that describes the
change in Delta, but as long
as you understand how Delta
changes, there is no need to
add Gamma to your list of
thingstoworryabout,atleast
inmyopinion.Aslongasyou
understand
that
Delta
increases as you go in-themoney and also increases
closertoexpiration,you’llbe
fine.
Stock Trader: That’s good
to know. So even if I buy
Calls a few strikes in-themoney I will not capture
100% of the price moves in
theunderlyingstocksbecause
the odds are not 100% that
they will close with intrinsic
valueatexpiration?
Optionz Traderz: That is
correctmostofthetime.
StockTrader:Thosearetwo
surprising points. First, even
in-the-money options do not
move 100% with the
underlyingstock,andsecond,
Delta increases as expiration
getscloser.
Optionz Traderz: That is
one reason that weekly dated
optionscostmoreinthelong
run than monthlies and
farther-out options. They
capture Delta values quicker
and lock them in faster. On
most weekly options, price
discovery at expiration
happens every Friday at the
close of regular trading. The
odds of these options
wandering
away
from
intrinsic value are generally
50% less than those of
monthly options, given that
they have three fewer weeks
in which to discover the
underlying stock’s price at
expiration.
Different
probabilities associated with
longer timeframes cause
differentpricevalues.
Stock Trader: We are back
totortoisesandrabbits,huh?
Optionz Traderz: Similar,
but unlike Theta and Vega,
Deltaisbasedontheoddsof
the intrinsic value still being
there at expiration. Those
odds are determined almost
exclusivelybythepositionof
the underlying price in
relationtothestrikeprice.An
at-the-money option will
usuallyhaveaDeltanear0.5,
regardless of the amount of
time to expiration or the
amountofImpliedVolatility.
An at-the-money option on a
rabbit stock has the same
chances of expiring in-themoney as one on a tortoise
stock;theoddsarealways5050. The same goes for an
optioncontractthatexpiresin
oneyearcomparedtoonethat
only has one day to
expiration. If it is at-themoney the odds are still 5050 and both would have a
Deltacloseto0.50.
Stock Trader: That makes
sense.SoifanearmonthCall
has a Delta of 0.5, and one
severalmonthsoutalsohasa
Delta of 0.5, why choose to
tradeoneovertheother?
Optionz Traderz: Good
question. It depends on how
youplantomanagethetrade.
Gamma measures how much
Delta is expected to change
when the underlying price
changes,andGammaismuch
lower on options with longer
term expirations. So if you
opt for the longer term, you
will experience much less
time decay, but you will get
much less move for the
moneybecauseDeltachanges
muchmoreslowly.
Stock Trader: So what do
you think would be the best
waytoconvertatrendtrading
stock system to options, with
Deltainmind?
Optionz Traderz: I would
say if you want to capture
maximum Delta, trade a few
strikes deep in-the-money on
near term monthly options.
You will pay much higher
premiumsthanyouwouldon
out-of-the-moneyoptions,but
you will capture Delta much
quicker. Not only would the
valueofyouroptionsincrease
much more on the in-themoney options, but you
would have opportunities to
take a larger chunk of your
profits off the table early if
your charts indicated a
possiblereversalofthetrend.
Also, when you are wrong
aboutthedirectionofatrend,
Deltawouldactuallydecrease
as your deep in-the-money
options get less deep. As
intrinsicvaluedecreases,time
value increases at an
accelerating rate and that
could help cut your losses.
Even with reduced losses,
youshouldcutyourlossesthe
same way you would if they
werestocks.
Optionssometimeschangein
value by much larger
percentages than stocks,
sometimes100%ormoreina
single trading day, so do not
let the percentage gains and
losses spook you. You are
actually using much less
capital but shooting for the
same dollar gains. Be
cautious about increasing
position size. If you are used
to trading 500 shares of
Apple then trade five
contracts, you may be
tempted to increase to 1,000
shares by using 10 contracts
for increased leverage; but
you can still lose the same
amount, dollar for dollar
initially, with larger trading
sizes that are in-the-money.
This could negatively affect
your risk management and
yourriskofruin.
Stock Trader: So keep my
positionsizesthesame?
OptionzTraderz:Yes,many
are tempted to trade huge
positions with all the extra
leveragethatoptionsallow.If
they get lucky the first time
and make a lot of money, it
makes them arrogant and on
track for a blow up. When
youhavetradedoptionsfora
few years, you may get to a
point where you are
comfortable
enough
to
increase your position sizes
using options for leverage,
butIwouldnotrecommendit
forbeginners.
StockTrader:Sooptionsdo
not suspend the rules of risk
management.LOL.
Optionz Traderz: No, but
for many traders options
increase the chances of them
gettingLasVegasfever.They
win big and lose big but
inevitably their big losses
outweightheirbigwins.
StockTrader:Really?
Optionz Traderz: Amateurs
are drawn like moths to a
flame to cheap, deep out-ofthe-money Call options.
Manydon’trealizehowmuch
the odds are stacked against
them, usually 10 to 1 or
worse. The sad thing is that,
as with all option strategies,
they would probably break
evenoverthelongtermgiven
asufficientnumberoftrades,
butmostlosealltheirmoney
beforetheygettotheonebig
win.
Stock Trader: So I need to
keep the odds in my favor
withmystocktradingsystem
by buying options that
already have intrinsic value,
so I do not have to be right
about the amount of the
magnitudeofthemoveofmy
stockasmuchasIneedtobe
rightaboutthedirection.
Optionz Traderz:
you’vegotit.
Now
StockTrader:Ineedtokeep
my position sizing the same
and manage my percent at
risklikeIalwayshave.
Optionz Traderz: Yes. If
you have always put 2% of
yourtotalcapitalatrisk,then
that is all you should be
risking with options. Stop
lossesworkwithoptionslike
they do with stocks. One
drawback to options is that
you need to be right about
direction and also overcome
the time value loss; that is a
variablethatyoudonothave
to worry about with stocks.
Theta decay needs to be
considered,
but
proper
position sizing and being
right with your trade will
greatly help this variable.
Vegashouldalwaysbeinthe
back of your mind too. But I
think you will find that most
ofthetimeitwillnotbetime
decayorvolatilitythataffects
your trade; it will be the
change in the price of the
underlying will determine
your profits and losses, and
Delta will show you what to
expect.
Stock Trader: O.K., I think
that was some great
information. Unfortunately
we are out of metaphors so I
amgoingtocallitamorning
andgosurftheweb.
OptionzTraderz:Foroption
information?
Stock Trader: No, I think I
will study the behaviors of
tortoisesandrabbitssoitwill
helpmeinmyoptiontrading.
Optionz Traderz: That is
funny.
It was now 10 a.m.
and Stock Trader was wide
awake,althoughhisneckwas
sore from sleeping in his
chair the previous night. He
was feeling more confident
than ever about trading
options. Optionz had given
him some valuable advice
about Theta and Vega, but if
he was going to profit from
options, he knew he would
need to study Delta a little
more. First, he needed to get
something to eat. He opened
the refrigerator, but found
onlyastalesliceofpizzaand
somemustard.Sohedecided
to go down to the
supermarketandgetapackof
energydrinksandafewother
supplies so he could study
some option tables on a full
stomach.
On the way to the
market,hegotstuckintraffic.
“Good Grief, here it is
Saturday morning, not rush
hour on Monday, and still
traffic is only moving at 20
miles an hour on an
expressway built for 65,” he
thought. As he sat in traffic,
his mind drifted back to
options and how Delta could
help
him.
Suddenly,
something Optionz had said
earlier started to make sense.
Delta is like the speedometer
on a car. He did not need to
concern himself with all the
variables that controlled the
speed of his car. To know
howfasthewasgoing,allhe
had to do was look at the
speedometer, and his was
peggedat20.
Stock Trader would
much rather be able to drive
at the posted speed limit and
get where he wanted to be
faster. He realized he was
probably saving some gas by
getting better fuel economy
driving at such a slow speed,
however, a speed of 20 was
not what he wanted. He
wouldmuchratherpayalittle
more for gas and get to the
supermarket and back home
much faster. It would
probablybenodifferentwith
options. To convert his trend
trading system to options, a
Delta of .20 would probably
not be what he was looking
for; a Delta of .65 would be
morelikeit,evenifitcameat
ahighercost.
“Finally,abreakintraffic,”
hesaidoutloud.Soonhewas
donewithhisfoodshopping
andonhiswayhometolook
upDeltaonsomeofthe
optionsforthestocksonhis
watchlist.Thetrafficwas
gonenow.“ItlookslikeI
won’texpireworthlessafter
all,atleastnotthisweek,”he
thought.
Chapter7
STOCKSFOR
RENT:
COVERED
CALLS
Oneevening,asStock
Trader was eagerly scanning
for who was online in his
Winning Traders group, he
looked through the list of
peopleonline:
RookieTrader
PennyTrader
GhostofDarvas
PennyPumper
“No
Optionz
Traderz?” He found himself
disappointed.
Helookedattheposts
onthegroup’swall.
He waded through
penny stock post after penny
stockpost.
ELAY.145x.16keepaclose
watchonELAY!!
“Whatgarbage.”
EXTO making some Noise
today!!!!
“Wow,
four
explanation points; that must
beareallyhotcompany.”
EXTOchurningnicelyhere
and bounced off its
support at .009, watch
fortheconsolidationto
continue while EXTO
sets up for its next leg
up!!!
“Whattheheckisthat
price? Could I buy 1,000
shares for a penny? Good
Grief!”
He was just about
nearing the point where he
could not take any more of
this
shameless
penny
pumping, but out of curiosity
heclickedthelink.
Hereadthatthequote
wasindeed.0094,butthenhe
sawthenameofthecompany,
“ExitOnlyInc.”
He found himself
laughing out loud. How
ironic that a penny stock,
which a trader probably
couldonlygetintobutnotout
of, would be named “Exit
OnlyInc.”Hecouldnothelp
it any longer; he had to post
his
opinion
on
the
conversationthread.
Stock Trader: This piece of
garbage should be named
“Entry Only Inc.” Group
members, you would be
better off just burning your
money than buying any of
these pink sheet penny
stocks;atleastthefirewould
give you warmth for a
minute.Youconmenneedto
getoutofthisgroup.
Feelingcompleteafter
hiscomment,hecontinuedto
look
at
topics
and
conversationthreads.
As he was browsing
through the topics and
threadsofthegroup,hecame
across a post from the night
before that he found
interesting. Then, as he
lookeddowntheconversation
thread, he saw his trading
buddy’s name. The thread
reallygrabbedhisinterestso
hebegantoreadit.
Income Trader: Anyone in
this group familiar with
sellingCoveredCalls?
Optionz Traderz: I have
studied and traded just about
everykindofoptionstrategy.
Income Trader: Do you
thinkCoveredCallswouldbe
a good way to generate
consistentreturns?
Optionz Traderz: I know
people who do that. They
makegreatreturnsintheright
market,withtherightstocks,
whentheymanagetheirrisk.
IncomeTrader:Really,how
dotheydoit?
OptionzTraderz:Well,first
they have to know their risk;
if you want to manage your
risk like they do, the
underlying stock on which
you write an option is the
key. That is where your risk
lies, in the stock going down
not in the option going up.
When you sell a Covered
Call, you collect the
premium. But just because
you are generating income
doesn’t mean you can ignore
the risk of the stock price
decreasing. If your stock
suddenly experiences a large
declineinprice,thepremium
wouldnotbeenoughtooffset
your loss. Your underlying
stocks should be with
companies that you believe
are great investments. The
stocks you pick will be the
key to the whole system
working.
Income
Trader:
What
should I look for in a stock
before I consider writing
Calls?
OptionzTraderz:Youmight
want to look for a stock that
you would consider to be a
good long term investment;
of course, you would need a
stock that not only has
options available on it, but
one which has options that
trade on good volume. You
really want stability, not
volatility. You need a solid
price support on the charts
from a technical aspect and
the company’s fundamentals
tobesolid.Intoday’smarket,
financial
stocks,
oil
companies, and technology
stocks are no longer the safe
bets they once were.
Financial meltdowns, oil
leaks, and a company’s
technology
becoming
obsolete are more common
thanever.
Income Trader: Wow,good
points. What am I looking
for? A stock I can call 'Old
Faithful' and is always
reliable?
OptionzTraderz:Ithinkso,
the kind of stocks Warren
Buffettlikes.Greatcashflow,
steady dividends, no real
competition, at a great price.
Lowriskideas.
IncomeTrader:O.K.,onceI
getallofmysuperstarstocks,
thenwhat?
Optionz Traderz: You can
write monthly out-of-themoneyCalls,basingthestrike
price of the Calls on a price
target maybe right above the
resistanceofthecurrentprice
of the stock. Or if that does
not provide reasonable
premiums,thenyoualsohave
the option to write threemonth-out in-the-money or
at-the-money Calls, over and
over,asameansofcollecting
the premiums with some
additional
downside
protection. With the more
recent availability of weekly
optionsoncertainstocks,you
could write an option at-themoney each week to lock in
your return, or one strike out
so you would keep all the
capital gains between the
starting price and the Call’s
strike price, and then just
write a new one over and
overeachweek.
Rookie Trader: I thought
you said this was not the
Holy Grail. You talked me
outofit;nowyouaretalking
himintoit?
Optionz Traderz: I am not
talking him into anything; he
askedmeaboutthestrategy.I
am getting to the down side.
Mymainargumentwithyou,
Rookie,wasthatyoubelieved
it was the Holy Grail, that it
couldn’t lose, and also that
you were conned by a black
boxtradingsystemwithback
fitted historical test results.
Weneverreallygotpastthat,
so I never got a chance to
explaintheproperwaytouse
Covered
Calls.
You
exhausted me just trying to
make you understand that it
was just one of many option
strategies.Butifyoueverget
serious about learning the
waymosttradersfindsuccess
with Covered Calls, I’d be
happytotellyou.
Rookie Trader: O.K., I am
allearsnow.
OptionzTraderz: Then step
away from the keypad for a
whileandread.
Income Trader: So are you
suggesting building an
investment portfolio of the
best and safest stock
investments,
and
then
overlaying that with Covered
Callstoenhancethereturns?
Optionz Traderz: That is
how the pros that I know do
it.Therearemoneymanagers
that run portfolios that do so
exactlythewayIexplainedit.
Theymakegreatreturnsover
the long term. You’ll
probably do best with a
diversifiedportfoliosothatif
oneofyourstockstakesabig
hit, you will offset the loss
with the income from the
others. You should also
consider diversifying across
differentsectorsforthesame
reason. Some traders I know
use ETFs instead of stocks
becausetheyhaveadegreeof
diversification built in. Still,
you need to be careful with
ETFs, especially those that
are devoted to one single
sector of the economy. By
using several safe underlying
stocks or ETFs, Covered
Callscouldputyouonapath
to much better returns than
you would normally expect
fromtradingequitiesalone.
Income Trader: Now the
downside?
Optionz Traderz: Yes, to
keep it real. Many traders
don’t realize that Covered
CallsareequivalenttoNaked
Puts. With Naked Puts you
takeonthefulldownsiderisk
of the stock for a small
premium,andthisisthesame
principleasCoveredCalls.If
Calls are sold in-the-money
or at-the-money you get no
benefit from any upside
movement. Just like Naked
Puts,youonlygettokeepthe
premium. The key is picking
the best stocks. If you pick a
stock, then it craters, it is
possible to lose a lot of
moneyquickly,evenwiththe
continuous selling of Calls
into a down trend and using
thebuyingbackandsellingof
new options like a parachute
to cushion losses. Sometimes
that parachute is just not
effective enough to prevent
you from crashing into the
ground. Choosing the wrong
stock early in this system
could hurt your capital. That
is why I advise you to
diversify if you are going
with a longer holding period.
If you decide to use shorter
term options, diversification
becomeslessofafactor.
Income Trader: Covered
Calls are like Naked Puts? I
still do not get that. Naked
Puts sound too risky. My
broker allows me to sell
Covered Calls but will not
allow Naked Puts. Why
wouldIbeallowedtodoone
but not the other if they both
have the same amount of
risk?
Optionz Traderz: O.K., say
you owned 100 shares of
Apple at $400 in September
and wrote a Call on it for
October at $400 for a $16
premium and it falls to $300
– what do you lose at
expiration?
Income Trader:
$10,000-$1,600…
$8,400?
Um…
Crap.
Optionz Traderz: Correct,
plus
commission
and
slippage. Now travel back in
timetoSeptemberanddothe
tradeagain.Thistimeyoudo
not own Apple but instead
yousellaNakedPutcontract
witha$400strikeinOctober
for$16anditthencrashesto
$300 at expiration; what do
you
lose
this
time?
Remember, you have to buy
Apple at $400 even though
themarketpriceis$300,soit
will be worth only $300 the
moment it is ‘put’ on you.
But you get to keep the $16
premium. Also remember,
100sharesisonecontract.
Income
Trader:
$400x100=$40,000,
$300x100=$30,000, $40,000$30,000=$10,000, $10,000$1,600=$8,400
Optionz Traderz: I was
getting worried you would
havetoopenaspreadsheetto
figurethatout.
IncomeTrader:Sorry,Iwas
never great at math. $8,400,
that is truly weird, that a
Covered Call acts like a
NakedPutatthesamestrike.
I never thought of that. They
have the same risk profile of
a Naked Put. I would never
have considered selling
Naked Puts, even if my
broker allowed it, because I
thought they were much
riskierthanCoveredCalls.
Optionz
Traderz:
A
CoveredCallislikeaprequel
toaPut;youaregettingpaid
for a stock you have already
‘put’ on yourself. Brokers
know how risky these trades
areandpreferyoutotakethe
riskonyourself,asaCovered
Call, instead of exposing
them to the Naked Put risk.
That is why Naked Puts
require a higher level of
privileges with most brokers.
It is not that Covered Calls
are less risky, it is that you
arecoveringtheriskyourself,
notthebroker.
Income Trader: Wow, very
insightful!Youshouldwritea
book.
Optionz Traderz: Maybe I
willoneday.
Income Trader: What about
overallmarketrisk?
OptionzTraderz:Whilethis
systemmayfeelliketheHoly
Grailofsystemsandlikeyou
can’t lose in bull markets,
bear markets will gobble this
system up. Calls and Puts
becomemoreexpensivewhen
a sharp downtrend causes
volatilitytospike.Thatmight
sound like a good thing
because you can collect
higher premiums, but the
higher premiums also come
with added risks. First, you
wouldbetakingonmorerisk
by holding shares of stock
whenthemarketispredicting
a generalized downturn.
Second,Deltashrinkswithan
increaseinvolatility,soCalls
change in value much more
slowlyinrelationtotheprice
oftheunderlying.Soifprices
did continue to decline,
Implied Volatilities would
likely rise, and with the
resultingcontractionofDelta,
youcouldsufferasignificant
loss on the underlying stock,
but make almost no profit
buying back the Call. The
slower rate of Delta would
cause the Calls to decline in
valuemuchmoreslowlythan
they would in times of low
volatility.
With
the
underlying price declining,
you would likely be able to
buythembackatalowercost
thanwhenyousoldthem,but
you probably wouldn’t see
much profit unless you kept
them open until expiration.
Waiting for expiration day
would mean risking even
greater losses on the stock,
unless you had the ability to
un-cover them. And I’m
assuming you don’t have the
ability to carry Naked Calls
with your broker because
they present an even greater
potentialrisktoabrokerthan
NakedPuts.
Income Trader: So if
volatility suddenly rose, I
might be better off staying
awayfromCoveredCallsfor
a while, at least until I got a
signal that the market was
nearingsupport.
Optionz Traderz: That
would depend on the degree
ofvolatility.Aslightincrease
shouldn’t scare you away. If
there was a minor correction
in the market and it
temporarily
drove
up
volatility, you might try
shortening the term of your
contracts, maybe to as short
asaweekortwo.Shortening
the term would allow you to
profitfasterfromtheCallsin
case the trade started to go
against you and could allow
you to get out of the market
much earlier in a scenario in
whichthat‘minorcorrection’
turned out to actually be the
beginning of a bear market.
Another thing to consider
would be selling the Calls
slightly in-the-money to give
you
some
additional
downsideprotection.Youare
correct, though, that in a
market which has fallen
through support levels and
volatility has increased
significantly, it is probably
best to avoid the temptation
of the higher premiums on
Covered Calls, at least until
thingssettledown.
IncomeTrader:Soitsounds
likeCoveredCallsareagreat
waytotrade.AllIneedtodo
is be careful about what
stocks I pick, adjust the
lengthofthecontractandthe
strike price based on
volatility, and stay out of the
market when it turns bearish.
That seems like it should
provide consistent profits
yearafteryear.
Optionz
Traderz:
‘Consistent’ depends on how
you define it. This system
will almost certainly have
losing years, but it wins over
the very long term through
discipline. You will usually
have to follow this system
long term in order to see the
benefits. Another part of this
systemthatmayseemstrange
is that you give up huge
potential profits in runaway
bullmarkets.Insuchmarkets,
you are collecting your
premium but missing the big
uptrend runs that your stocks
may experience. I knew one
person who called the
Covered Call system a stop
gain, because your short
option limits your upside. In
runaway bull markets you
only collect the premium; in
viciousbearmarketsyoutake
the full drawdown minus the
Calloptionpremium.
Income Trader: Well, that
doesn’tsoundgood.
OptionzTraderz: Well,itis
not that I am trying to be
overly negative. All option
strategies work well under
certainmarketconditions,but
not in others. They are
profitable based on whether
the market environment is
conducive to that particular
strategy. A big key with the
Covered Call system and all
otheroptionstrategiesforthat
matter is controlling risk. All
the stocks in your portfolio
should have stop losses
predetermined.Theycouldbe
at a price that is under what
you perceive as support in a
chart, or they could be a
percentage of loss you are
willingtoaccept.Ifthereisa
major negative breakingnewsannouncementaboutthe
stock on which you have
Short Calls, by all means cut
yourlosses;sellthestockand
buy back the Calls. After the
storm has passed and
everything has settled down,
you may be able to buy it
backatagreatpriceandstart
allover,writingCalls.
Income Trader: I really did
not even think about
controlling risk; it hadn’t
even entered my mind. I was
so focused on the Call
premiums.
Optionz
Traderz:
Controlling risk is one of the
most important parts of any
successful option trading
system. Do not forget when
you look at historical charts
that if your stock had a huge
run up before an earnings
announcementandyouhadto
give that up to the option
buyer when you bought back
the Call, then it subsequently
tankedafteryouwroteanew
Call, you would have given
up all of the gain and taken
on all of the loss, with only
thetwopremiumstooffsetit.
Income Trader: I never
thoughtofthateither.
Optionz Traderz: Another
costofthestrategyisthatyou
have to pay a commission to
buy the stock, then a
commission to sell the Call,
and yet another commission
to either buy the Call back
before expiration or allow it
to be exercised. You should
consideralloftheseexpenses
and make sure the options
you are selling have enough
premiums to make it
worthwhile.Youwillneedto
sell Calls at the right
timeframes to collect enough
premiums
to
offset
commissions. With many
stable big cap blue chip
stocks, the relatively low
premiumscausedbytheirlow
Implied Volatilities might
require selling two- or threemonth-outoptionsinorderto
getabigenoughpremium.
Income Trader: Wow! That
isalottothinkabout.
Optionz Traderz: The good
news is that great companies
tendtohavestableprices,and
historically the overall stock
market has trended up more
than down. If you buy the
right stock at the right price
andtradeCoveredCallsonit
in a bull market, you could
potentially
remove
the
underlying cost of the stock
in a matter of a few years,
sometimesless,andthereafter
be playing with the house’s
money. With Covered Calls,
you win if the stock goes up
or stays the same. You also
break even as long as it does
not go down as much as the
Call premiums you received.
Youonlyloseifitgoesdown
morethantheCallpremiums
youcollect.
Income Trader: Better odds
and more ways to win? But
with less potential upside
profits and the full downside
stillopenafterthepremium.
OptionzTraderz:Yougotit.
Andhere’sonemorethingto
think about. Because a
CoveredCallbehavesexactly
thesameasaNakedPut,you
might find it helpful before
you trade a Covered Call to
ask yourself: “Would I place
thissametradeifIwasusing
a Naked Put instead?” Say
you wanted to sell a Call on
those 100 shares of Apple
stock you owned in
September, when it was
trading for $400. You might
be tempted to sell a Covered
Call at the October $410
strikefor$12;butwouldyou
sell a Naked Put at the same
strikeandexpirationfor$22?
Income Trader: Wow, I
never thought of it like that
before. I guess I would be
much more cautious about
selling the Naked Put, but in
reality, I would be opening a
trade that had the same
potential profit or loss as a
NakedPut.
Optionz Traderz: Exactly.
Like most traders, if you
chosetosellaNakedPut,you
would probably choose one
that was out-of-the-money to
avoid some of the risk of
having it get exercised. You
wouldn’t collect as much
time premium as selling atthe-money, but you would
loweryourriskofassignment
considerably. If you were
going to sell a Naked Put on
Apple, maybe you would
choosea$390strikeifitwas
trading at $400. If a Naked
Putatthatstrikemakessense,
then a Covered Call at the
$390strikeshouldalsomake
sense.Solet’ssayyouchose
to sell one Call contract for
Octoberatthe$390strikeand
collected the $22 premium;
how would this affect your
lossifthepricefellto$300?
Income Trader: Give me a
minute…IthinkIcandothis
one without a spreadsheet
too.
$400x100=$40,000,
$300x100=$30,000, $40,000$30,000=$10,000, $10,000$2,200=$7,800. Crap, that’s
still a $7,800 loss, but is
better than the $8,400 loss I
wouldhavehadonanat-themoneyCoveredCall.
Optionz Traderz: Now for
thebestpart:damagecontrol.
Let’s say Apple immediately
falls from $400 to $390 the
day after you sell a Covered
Call at the $390 strike. You
could roll the Call down to
$380 and maybe collect an
additional$6premium.What
doyouthinkwouldhappenif
you continued to roll down
andthepricecontinuedtofall
$10everydayfor10days?
Income Trader: Hmm…
Well,Iwouldultimatelylose
$10,000 on the stock, but I
would collect $600 in
premiums each time I rolled
down, so I would get back
$6,000 there, plus I would
keep the original $2,200
premium
$10,000-$6,000$2,200 =1,800. So by
managing the trade, I could
cut my loss from $7,800 to
$1,800?
Optionz Traderz: You got
it! And at the expiration of
the final contract, you could
roll it out to the following
month and cut your loss
almost to zero, if the price
had finally found support; or
you could simply choose to
hold onto the shares that you
now owned at a very
favorablecostbasis.Theonly
scenario where you will lose
money rolling Calls down in
adowntrendisonewherethe
stock price falls too quickly
to be able to capture enough
additionalpremiums.
Income Trader: You’ve
given me some great ideas. I
never would have thought to
consider selling Covered
Calls in-the-money. I have
always looked at the out-of-
the-moneyones.
Optionz Traderz: That is a
viable system for an investor
who is looking to simply
supplement the growth of a
portfolio with some extra
income. But for an option
trader whose priority is to
generate income, in-themoney Covered Calls are a
much better choice, in my
opinion. You give up all of
theincreaseinintrinsicvalue
in an uptrend, and although
you do run a slightly higher
riskofearlyassignment,such
anassignmentwouldresultin
you keeping the entire
premium.Allyouwouldneed
to do would be to buy the
stock back and start selling
Calls again. But you give
yourselfamuchbetterchance
to be able to cut your losses
byrollingin-the-moneyCalls
downduringadowntrend.
IncomeTrader:I’mnotsure
I understand that. Wouldn’t I
be able to roll down out-ofthe-money Calls the same
way?
Optionz Traderz: Yes and
no.Youwouldbeabletoroll
themdown,butDeltaonoutof-the-moneyoptionsismuch
lower than those that are inthe-money, so each time you
rolled,youwouldcaptureless
ofthemoveoftheunderlying
than you would with in-themoney Calls. You should
keep in mind that the time
value on a Call that is $10
out-of-the-money is the same
as the time value on one that
is $10 in-the-money. For
example,withAppleat$400,
the$390strikeOctoberCalls
on Apple might have $12 in
time value and $10 in
intrinsic value for a total of
$22; meanwhile the Calls at
the $410 strike would only
have$12intimevalue.
So, you can see the effect
Delta would have if you
consider the process of
rolling Calls from at-themoney,wherethepremiumis
$16 to a strike $10 lower
wherethepremiumis$22,in
this case netting you a $6
credit.Butrollingthemdown
the same amount when they
are $10 out-of-the-money
onlygetsyouabout$4which
is the difference between the
$12
out-of-the-money
premium and the $16 at-the
money premium. When you
arerollingCallsdownthereis
a big difference between a
Delta of 0.6 and a Delta of
0.4.
Income Trader: That’s a
good point. So I guess it
comesdowntowhetherIam
trading options strictly for
income, or whether I am
using them as a means of
supplementingtheincomeon
mystocks.
Optionz Traderz: Exactly.
Every trader is different, so
you have to choose which
method makes you more
comfortable. When times are
good and prospects for
growth look favorable, you
might feel more comfortable
simply collecting the $12
time premium on the out-of-
the-money Calls and then
realizing some gains in the
underlying stock during an
uptrend. However, if the
market is questionable, you
should at least consider the
fact that selling them $10
deep in-the-money would
generatethesame$12intime
premium.In-the-moneyCalls
not only give you extra
downsideprotection,butthey
offer a much better
opportunitytorollthemdown
tocutlosseswhennecessary.
Either method has an equal
potentialtobeawinninglong
term trading system, but it’s
up to your individual
preferences to choose which
stylebestfitsyourpersonality
and the current condition of
themarket.
Income Trader: You’ve
givenmealottothinkabout.
Thanksforalloftheadvice.
Optionz Traderz: Before
you go, you should also
consider another method of
damage control. It is not
possiblewhenyouaretrading
a high priced stock like
Apple, where you are only
trading one contract; but on
lower priced stocks you can
reduce the number of
contracts when the price
moves against you. Let’s say
you bought 600 shares of
Xerox in September for $27
and sold six Calls at the $25
October strike for $3 each.
Again, assume the price
immediately starts dropping
and ends the first week at
$25. While you are safe for
themomentbecausetheprice
is still higher than your net
costbasis,youwouldhavean
opportunity to lower your
risk.Todoso,youcouldbuy
back two of the Calls,
probably at a profit of about
$1 each and then sell 200
shares of the stock at a $2
loss per share. To make up
for the $1 net loss, you can
then roll the remaining four
CallsouttoNovember,stillat
the $25 strike, and probably
collect an additional $1 per
contract.
Income Trader: That makes
a lot of sense. I would be
lowering my risk by cutting
thenumberofsharesIowned
from 600 to 400 in case the
price continued to drop. And
by rolling the remaining
contractsoutforanadditional
month, I would collect
enoughpremiumstonotonly
cover my loss on the 200
shares I sold, but also give
myselfsomeaddeddownside
protection on the ones I still
owned.
OptionzTraderz:Exactly.It
sounds like you’re really
starting to understand what
Covered Calls are all about.
I’mgladIcouldhelp.
Income Trader: Very much
so.Thanksagain.
Optionz Traderz: You’re
welcome.Oh,Ialmostforgot,
there’s one more thing I
wantedtotellyoubeforeIgo.
Try not to let any initial
losses scare you away from
sticking to your system. I
once met a guy who sold inthe-money Covered Calls on
a stock that immediately
starteddroppinginprice.The
story,ashetellsit,isthathe
was able to continuously roll
the Calls out and down, and
although it took him ten
months, he was eventually
able to get out of the trade
with a small net profit when
thestockeventuallybottomed
out.
Income Trader: Wow, that
really makes Covered Calls
seemlikeagreatsystem.
Rookie Trader: Maybe they
trulyaretheHolyGrail.
“That guy never
stops,”saidStockTraderout
loud.
Chapter8
SELLING
LOTTERY
TICKETS:
NAKED
OPTIONS
“Upandat‘em!”
Stock Trader had
gotten into the strange habit
of talking to himself in the
early morning hours as if he
and his body were two
differentpeople.
He would know he
needed to get up and get to
work each morning. He
would know he needed his
paycheck to pay bills.
Unfortunatelyhisbodywould
not be cooperative. It loved
sleep.
“O.K., I need to get
upnow,”StockTradersaidas
thealarmdronedon.
Snooze.
“Good, another ten
minutes.”
Ten minutes later he
wasup,gettingdressedwhile
consuming an energy drink
(not a small one, but one of
thedouble-sizedbigboys).
“I wish my energy
drink came in a Big Gulp
size,” he thought, only half
joking.
After throwing a little
fitinhismindaboutworking
today, he was eventually on
the road, showered and
shaved, with tie locked in
place.
“Crap,Ineedgas!”
He discovered that he
wasnottheonlyonerunning
on empty this morning. His
gas tank was dangerously
dumpedon“E”.
He stopped at his
favorite gas station and
pumpedgasuntilhistankwas
full.
“Goodgrief,over$50
to fill the tank of this little
truck?”
He walked into the
gas station for his second
energy drink of the morning,
a new personal record for
caffeineconsumptionsoearly
inthemorning.Ashewaited
inlinehethoughtitwouldbe
a good idea to break this
habit; it couldn’t be good for
him.
It was a busy
morning. The station had
three lines open, one
apparently for lottery tickets
only. The multi-state power
ball jackpot was up to $400
millionnowandpeoplegrew
more interested and greedy
bytheday.
Stock Trader started
tothinkaboutthis.
“What a ridiculous
plan, spending hard-earned
money for a 1 in a 100
million shot to win. Or were
the odds even worse than
that?”
He had once heard
thattheoddsweremuchmore
infavorofgettingkilledina
car wreck on the way to
purchase the lottery ticket
than to actually win a big
jackpot.
The popular phrase,
“Somebody’s got to win,”
wasevenlessimpressive.His
thought was: “That is not
really true; the only reason
the jackpot is so high is
because week after week has
passed without a single
winner; and even though
somebody’s got to win
eventually, millions and
millionshavetolosetoo.”
Contrary to the
opinions of his co-workers,
he did not gamble in his
trading; he played in favor
with the odds. In the lottery,
everyone thought they would
be that one person who beat
the odds. Most of his coworkers played the lottery,
where they had no control
overtheodds.
He was getting closer
tothefrontofthelinenow.It
seemed like every person in
front of him was buying
lottery tickets. Some were
buying just one. Others, like
the older lady who he was
behind in line, were buying
several.
“What a bunch of
suckers,”hethought.
When he finally got
up to the front of the line to
pay, he asked the clerk a
question. “Are you always
thisbusywiththelottery?”
“The bigger the
jackpot, the busier we get,”
thecashierreplied.
“So the more money
they think they will win the
more they spend for a
chance?”askedStockTrader.
“Correct,” the cashier
responded.
As Stock Trader
turned towards the door, he
saw that the line now snaked
all the way down the bread
aisle and past the dairy
cooler.Hethoughttohimself,
“They really have no regard
for the odds. The odds of
winning aren’t any better
when the jackpot is higher.
Thejackpotissoridiculously
high anyway; why would
they wait in line to play for
400milliondollars,butavoid
playing when the jackpot is
only 40 million? Isn’t 40
million enough for the
lifestyle they want? The
states are able to make
billionswiththisgame.These
customers would make much
moremoneyiftheywereable
toselllotterytickets,notbuy
them,”
Stock
Trader
concluded.
As he walked to his
truck he thought, “Hmm,
selling lottery tickets. I am
surethatOptionzwouldhave
some opinions about how to
do that most effectively by
usingoptions.Itmakessense
though. How profitable
would it be to take the other
sidesofbetswherethebettor
has no regard for the odds
againstthem?”
Stock Trader had
trouble focusing on his work
and getting through the day.
Hismindkepttryingtofigure
out the best way to profit
from selling options. He
picturedhimselfsellingreams
of scratch off lottery tickets
and making far more money
thanhepaidtothewinners.
On his drive home at
the end of the day he kept
trying to remember option
pricing on the far out-of-themoneyoptions.
Whenhegothomehe
followed his tradition of
goingstraighttohiscomputer
andtohisonlineworld.
He first looked at the
optionpricesforApple.Over
thepastsixmonthsApplehad
only penetrated its 200-day
moving average once. If he
sold front-month options at
the 200-day moving average,
would he win five out of six
months?
“What is that, about
an83%winrate?”
“What is the price of
nextmonth’sPutsatthe200day $350 level? Let’s see…
With three weeks left to
expiration, it is $3.00 for the
$350strike,whileAppleisat
$400, and it has a Delta of
-.13. So that would imply an
87% chance that they would
expireworthless?Ilikethose
odds,” Stock Trader thought,
viewing the online option
calculator. “Even if I only
sold two contracts, I would
have an 87% chance of
making $600; much better
oddsthanthefolksatthegas
station had of winning the
lottery.”
Hethoughtabouthow
sellingUncoveredCallsatthe
$450 strike would probably
gethimthesamepremiumas
the $350 Puts. “I would not
want to sell Uncovered Calls
on a hot stock like Apple,
though;thisthingcouldgoto
the moon at any earnings
announcement.” Still, it was
somethingtothinkabout.
“I wonder if Optionz
isinactiononline.”
As Stock Trader
signedonhesawthatOptionz
Traderz was online; he
decided he would cut to the
chase.
StockTrader:Optionz,what
are your thoughts about
selling far out-of-the-money
Naked options for cash flow
andreturns?
Optionz Traderz: Hey, I
didn’t see you join in. Ooh,
options‘aunat-u-rel.’
Stock Trader: I was
considering whether it would
be worthwhile selling Naked
Puts on Apple near the 200day moving average, which
have a Delta of about .10.
Thoughts?
Optionz Traderz: The good
newsisthattheoddsareway
in the sellers favor with the
farout-of-the-moneyoptions,
especiallywiththe.10Deltas.
Thatmeansyouwinnineout
oftentimes.Thebadnewsis
thatyoudonotgetpaidvery
wellfortakingonthefullrisk
of a major move going
againstyou.
Stock Trader: What do you
mean?
Optionz Traderz: Well,
everything is great when you
have those nine wins in a
row;youmaythinkyouhave
found the Holy Grail of
trading. Then that darn 1 in
10 loss could take back the
other nine wins. One huge
move against your position
can wipe out the entire sum
of the nine little profits; or
worse yet, a 1 in 100 loss
could blow up your entire
account. Black Swans are
vicious.
Stock Trader: Huh? First
turtles, then rabbits, and now
there are birds involved in
optiontrading?
Optionz Traderz: Ha ha,
sort of. For most of the
history
of
Western
civilization people thought
blackswansdidnotexistand
were impossible; all swans
were white. This was
generally accepted as fact
untilexplorersstumbledupon
the first black swans. Oops,
theywerewrong.2008wasa
Black Swan year in the
financial markets. Many of
thethingsthathappenedwere
thought to be impossible.
Didn’t
housing
prices
consistently go up following
WorldWarII?Citigroupand
Ford could never trade for
under a dollar; Bear Stearns
and
Lehman
Brothers
survivedtheDepression;they
couldnevergobankrupt;AIG
and General Motors were
DJIA components they could
not go bankrupt, and on and
on. Black Swans are
discovered more often than
investorswouldsuspect.You
have to be eternally vigilant
when selling Naked options,
sothefirst‘impossible’event
willnotbeyouraccount’slast
trade.
Rookie Trader: You are
alwayssonegative.
OptionzTraderz:Iambeing
negative for a reason. You
must always consider risk
first and go from there. But
onceyouunderstandtherisk,
there are ways to make
money
trading
Naked
options.
StockTrader:Goon.
Optionz Traderz: Some
traders start winning with
Naked Puts and get the
seductive siren call to keep
increasing their position
sizes.Theystartbelievingthe
unthinkable can’t happen,
untilitdoes.
StockTrader:Besides2008?
Optionz Traderz: Well, for
another example, the 1987
Black Monday crash. That
daynotonlyblewuptraders'
accounts but some of them
took down brokerages with
them. The reason that the
margin requirements are so
different for Naked options
versusCoveredoptionsisthat
theriskisonthebrokerageif
thetradercan’tcoverit.
Stock Trader: Yes, 1987
was not a good time for
NakedPuts.
Optionz Traderz: That year
was a rocket ride up and
seemed to be a Put seller’s
paradiseuntilOctober.
Stock Trader: So October
took everyone off guard?
Thatiswhyriskmanagement
is#1again?Howdidyoudo
thatyear?
OptionzTraderz:Iwasway
too young to have been a
trader then. I was in
elementary school in 1987. I
learned this from books and
studying charts. The Flash
Crash of 2010 was another
BlackSwan,andIwasinthe
market during that one.
Fortunately, I was trading
Naked Calls at that time and
none of my trades were
affected.
Stock Trader: You are a
younggun,huh?
Stock Trader had
alwayspicturedOptionzasa
50-something, middle-aged
man;itwassurprisingtohim
that someone under 40 had
this level of knowledge on
trading. He wondered if
Optionz was younger than
StockTraderhimself.
Optionz Traderz: Young
and strong. Anyway, like all
other systems, it is not about
howmuchyoumakebuthow
much you keep. Before you
sell any Naked option, you
need to go ahead and have a
stop loss where you will buy
it back if you are wrong. Or
you may want to place a
contingent order to buy or
shorttheunderlyingsharesif
thepricereachesadangerous
level, or even trade another
option to offset the risk. You
need an ‘abort’ plan or
adjustment plan for that
eventual bad move against
you.
StockTrader: O.K.,whatto
sell?
Optionz Traderz: The
methodologyinsellingNaked
options is no different than
stock trading. You could sell
Naked Puts under what you
believeisapricesupportand
sell Naked Calls above what
youbelieveisresistance.You
must consider the timeframe
also. If you are selling onemonth-outoptions,youmight
consider selling your Naked
option at a price that is
unthinkable for the stock to
get to within a month. In
selling options you are
dealing with both price and
time. While selling a onemonth-out Naked Put at the
200-daymovingaverage,ina
hot market’s leading stock
thatismakingall-timehighs,
the buyer of your Put may
have no chance of the stock
getting to that strike. If you
sell it a year out, then you
suddenly have a much better
chance of your strike being
hitsometimeduringtheyear.
StockTrader:Priceandtime
mustbothbeconsidered.
Optionz Traderz: You
should keep in mind that the
options are always priced at
fair value at the precise
moment that the contract is
opened. In today’s world,
there are few if any options
thatareover-pricedorunderpriced. Taken at face value,
optionsareazero-sumgame;
the premium of every option
reflects the odds that it will
create neither a profit nor a
loss for both the buyer and
the seller upon expiration.
That’snottosaysellersdon’t
have an advantage over
buyersbecausetheydo.
Stock Trader: Wait a
minute! You said options
were a zero-sum game. How
can the seller have an
advantage?
Optionz Traderz: Actually,
sellers
have
several
advantages. First, taking into
account all options at every
possible
strike
price,
statistically sellers will profit
about twice as often as
buyers; sellers, as a group,
win about 67% of the time.
Sellers of out-of-the-money
options have even better
odds. Even the lowest
performing options for
sellers,thosethataredeepinthe-moneywillstatisticallybe
winnersmorethan50%ofthe
time.
Stock Trader: But as you
have said before, sellers win
more often, but when they
lose,theylosemore.
Optionz Traderz: That is
correct,butsellershavemuch
better odds of starting with a
profit right out of the gate,
whereas buyers often begin
with a string of losers and
then have to run the race
playingagameof‘catchup.’
Sellers then have the option
of quitting while they are
ahead, while the only choice
for a buyer is to keep trying
ortakealoss.Ofcourse,I’m
not implying that this
statistical advantage is a
reason to choose selling over
buying; in my opinion that
preference should depend
onlyonthemarketconditions
atthetimeofthetrade.ButI
find it reassuring to consider
the advantages when I sell
Nakedoptions.
StockTrader:Goodpoint.If
I know I have an advantage
when I trade stocks, it gives
me confidence. I guess the
same would be true of
options.
Optionz Traderz: Here’s
another advantage of selling
that may boost your
confidence when you sell
options: premiums are often
inflated to account for Black
Swans. Just as an example, I
looked up those Puts on
Apple that you were talking
about. The closest ones I
could find to a .10 Delta for
next month were at the $350
strike and the last trade was
$3.00. That means the $3.00
premium
reflects
the
probabilitythatApplewillbe
trading at a price somewhat
higher than $347 one month
from now, a point where the
sellermakesasmallprofit.
Stock Trader: O.K.. That
first part makes sense. So
with Delta being 0.13 on
those Puts, there is a 13%
chance that the underlying
price will be $347 a month
from now. So why are you
now saying that the Puts at
the $350 strike would be
pricedinfavoroftheseller?
Optionz Traderz: You are
correct that in theory the
premium is based on the
probability of the underlying
price falling to $347, which
would be the point where
buyer and seller both break
even. However, that $347
value is not based on the
Black-Scholes model, which
assumesthatstockpricescan
generally predicted by a bell
curve. In reality, over
extended periods of time
prices do not conform to a
perfectbellcurvebutonethat
has fat tails. The fat tails are
causedbyBlackSwanevents
and also by unexpected
earnings or other good news
that causes unprecedented
run-upsinacompany’sstock
price. Over a period of 10 or
20 years, such unpredictable
events are likely to occur
several times, so the stock
actually spends more time at
the edges of the bell curve
than would otherwise be
expectedbypurelytheoretical
models.That’swhatgivesthe
bell curve its fat tails.
Emotions do have an effect
on trading, and those
emotions occasionally do not
fit an un-emotional statistical
model.
Stock Trader: This is really
interesting.Goahead.
Optionz Traderz: Well, we
already talked about Black
Swans, like the Crash of
1987, and I know you know
about Darvas because I saw
you chatting with another
trend trader about his
methodsawhileback.
Stock Trader: Wow. You
have a great memory. O.K.,
goon.
Optionz Traderz: Well,
Darvas noticed that stocks
tended to rally after they had
broken through a resistance
level, or ‘box.’ So someone
sellingafarout-of-the-money
Naked Call might not realize
that they were taking on a
hidden risk, that if the stock
had broken through to such
an‘unthinkably’highpriceas
the strike price of that Call,
there was a good chance it
wasoutofitsboxandheaded
forfurthergains.Likewise,if
a Naked Put seller saw the
underlying fall to their
‘unthinkable’ strike, it would
mean that the ‘unthinkable’
hadalreadyoccurredanditis
quite likely the price would
fall even further. That
concept was pretty much
ignored until 1987. A lot of
Naked Put sellers had not
considered that if a Black
Swan event occurred and
their far out-of-the-money
strikeshadbeenhit,therewas
a good chance they were
headedforsignificantlosses.
Stock Trader: I had never
thought of that. So I guess I
should expect far out-of-themoney options to be priced
based on the stock either
enduring a 1987-style Black
SwanoraDarvas-stylerally.
Optionz Traderz: Exactly.
The further out-of-the-money
you go, the more likely it is
thatthestockpriceisheaded
for a radical move if it
surpasses your strike. You
canactuallyseetheeffecton
historical charts. Prior to
1987, Implied Volatilities
basicallyraninastraightline
fromveryhighvolatilitiesfor
deep in-the-money options to
very low volatilities for far
out-of-the-money
options,
whatmanycallthe‘Volatility
Skew.’ After 1987, Implied
Volatilities have taken on a
curved appearance that some
traders call the ‘Volatility
Smirk.’ Implied Volatilities
are higher at the edges than
would otherwise be expected
by purely statistical models.
Theresultisthatdeepin-themoney and far out-of-themoney
options
have
premiums that reflect the
addedriskofeventsthatonly
occur rarely, maybe once
every few years or even as
much as twenty years. The
end result is that today’s
optionshavepremiumswhich
aremorereflectiveofreal-life
trading. I’m sending you a
chart that shows the Implied
Volatility Smirk for the
November 2011 Calls on
IBM.
StockTrader: That makes a
lot of sense. The options
market is truly efficient, so
much so that it adapts and
learns from changes in the
market.Sowhydidittakethe
Crash of 1987 to change the
way option premiums are
determined?
Optionz Traderz: In early
1987, options were still a
relativelynewproductforthe
generalpublic.Thepremiums
of out-of-the-money Puts
were mostly based on the
opinion that if a strike was
hit, the underlying price
probablywouldn’tgoveryfar
beyond that point. Then the
Crashof1987showedtraders
that they had been wrong; if
an out-of-the-money Put
strike is hit, especially one
thatisfarout,thereisagood
chancethatthepricecouldgo
wellbeyondthatstrike.
Stock Trader:
I never
thoughtofitthatwaybefore,
but you’re right. If a stock
was performing well and
somethingsuddenlyhadsuch
anegativeaffectthattheprice
fell through the 200-day
movingaverage,Iguessthere
wouldbenoreasontoexpect
that my strike price still
representedasupportlevel.
Optionz Traderz: You’ve
got it. Today’s options
market, having learned an
important lesson from past
Black Swans, prices out-ofthe-moneyoptionsatahigher
premium
than
would
normally be predicted by a
purely theoretical model, to
guard against losses that
sellers would endure if there
wasarepeatofthoseevents.
Stock Trader: I think I see
what you are getting at. In
theory,the$3.00premiumof
the $350 Puts on Apple is
based on the probability of
thestockpricefallingto$347
on expiration day, but that
probabilitytakesintoaccount
events that rarely occur. So
everymonththatoneofthose
rare events does not occur,
thesellerhasbetterodds.
Optionz Traderz: You
nailed it! I think that’s
another reason for the
widespread perception that
option sellers make more
money than option buyers.
Sudden, unexpected rallies
and Black Swans are priced
into every option, and if you
consistentlyselltheseoptions
over a long enough
timeframe,
you
should
accumulate enough of their
‘bonus’ premiums to pay for
an occasional radical price
move. So most of the time,
option sellers make more
profits than option buyers. In
addition, experienced option
sellers take steps to protect
themselves, so they collect
the
extra
premiums,
sometimesforyearsatatime,
while also limiting their
losses when a Black Swan
plays out. Successful sellers
of Naked options are like
lottery agents who collect
money from selling tickets
andthenshutdowntheentire
lottery at the first sign that
one of those tickets contains
thejackpotnumbers.
StockTrader:That’sagreat
point. We seem to be on the
same wavelength here. I was
thinking just this morning
that selling Naked options is
like selling lottery tickets. I
guess what you are saying
makes sense. If I am
collecting lots of income by
selling options at-the-money
that have lots of time
premium, it’s like I am the
government running a lottery
when the jackpot is $400
million. Because of the large
number of people buying
tickets,thereislikelytobea
sufficient
amount
of
premiums to pay all of the
winners. But if I sell options
far out-of-the-money, it is
like I am selling lottery
tickets when the jackpot is
small. Although the odds of
having to pay a winner are
much lower, with fewer
peoplebuyingtickets,thereis
a much greater chance that I
will end up paying out on a
winning ticket before having
collected much money in
sales.SoifIamgoingtosell
Naked Puts on a stock at a
price far out-of-the-money
that I believe represents
support,howdoImanagethe
tradetoprotectmyselffroma
BlackSwan?
Optionz Traderz: First, if
the odds are very small that
the price will be reached in
the allotted timeframe, then
the price you will get for the
option will also be very
small. You have to always
ask yourself: “Is it worth the
risk?”There’snoneedtosell
aNakedPutfortencentsifit
means you are risking
thousands of dollars; sure,
you will most likely get to
keep the $10 premium per
contract,buthowmanytimes
would you need to do that to
cover the losses on even one
badtrade?
Stock Trader: So, I guess I
need to sell far enough outof-the-money to give me
goododds,butnotsofarthat
the premium is too small to
makeupformylosses.
OptionzTraderz:Again,yes
and no. It might sound
counterintuitive,butyoumay
actually find that it is more
profitabletosellPutsthatare
deepin-the-money.
StockTrader:Huh?
Optionz Traderz: I know it
sounds crazy, but hear me
out. Assuming you were still
interested in trading those
Puts on Apple that you were
talking about when it was
trading at $400, you would
sell Naked Puts at the $350
strike for $3.00. As long as
the underlying price stayed
above$347,youwouldmake
a profit. The most profit you
could make on that trade
would be $3.00. Now,
consider that the time
premium on the $450 Puts is
also$3.00.So,whynotsella
Putatthe$450strikeinstead?
Stock Trader: You’re right
so far, that does seem
counterintuitive.
Optionz Traderz: O.K., so
let’s walk this though. Say
yousella$450Putfor$53.00
and then short 100 shares at
$400. Now, if the stock does
fall to support at $350 you
still get the same $3 profit,
becausewhenthestockisput
on you at $450 it will cover
the shares you shorted at
$400 for a loss of $50, but
you will keep the $53
premium.
Stock Trader: I never
thought of that, shorting a
stock and selling an in-themoney Put. I guess it would
behave the same as a Naked
out-of-the-money Put, but I
would be protected if the
stockfellthroughsupportand
keptongoing.
Optionz Traderz: That is
true; you would have much
more downside protection.
But always remember what I
said about options and risk:
the risk never goes away, it
just gets shifted somewhere
else. In this case you have
totally eliminated your
downside risk, but only
becauseyouhaveshifteditto
the upside If Apple suddenly
climbsabove$453,youhave
used up all of the gains you
would receive when the Put
expires worthless, but you
now are in a position where
you will have to buy 100
shares at a higher price in
ordertocoveryourshort.
Stock
Trader:
Wait
a
minute,isn’tthatexactlylike
aNakedCall?
Optionz Traderz: Bingo!
Any position you can create
with a Put can also be
synthetically created with a
Call at the same strike price.
Shortingastockandsellinga
Put, which is often called a
Covered Put, is equivalent to
aNakedCall.
Rookie Trader: That’s
stupid.Ifitispossibletouse
a Call to trade the same
position as a Put, why are
therebothkindsofoptions?
Optionz Traderz: It’s not
stupid, although I have to
admit,youhavefinallyasked
a really intelligent question.
For many traders, Naked
options are not available, so
they have no choice but to
use the equivalent synthetic
position. But mostly, it all
comes down to whether you
want to tie up your assets
withonestrategyorfreethem
up for use in other trades. It
also
involves
your
psychologyandhowyouplan
to manage the trade once it
hasbeenplaced.Ifyousella
Covered Call and the
underlying price falls, you
might not mind owning the
underlying shares. On the
other hand, someone selling
the equivalent Naked Put
might not want to own the
stock at all. In fact, a Naked
Put seller might be prepared
toshortthestockifthestrike
pricewashit.
Rookie Trader: I’m sorry I
said it was stupid. I really
thoughtoptionsweregoingto
be easy to learn, but
sometimes they just seem so
complicated.
Optionz Traderz: Apology
accepted. There are also
margin requirements to
consider. If you buy a Call,
your account only needs to
have enough equity to cover
the premium; but if you buy
the underlying and buy a Put
you will need a lot more
equity, not only to purchase
the shares but also the Put.
But I don’t want to mislead
you here. Just because you
canbuyaCallwithverylittle
equity doesn’t necessarily
mean you shouldn’t have
enough purchasing power to
buy the underlying shares. If
the Call goes in-the-money
and you don’t have enough
equity to buy the stock, you
will be forced to sell the
option before it expires in
order to avoid a margin call,
and that would mean you
would give up any future
gainsyoumighthaverealized
onthestock.
Rookie Trader: That makes
sense. I just wish I could
learnthisallmuchfastersoI
could start making big time
money.
Optionz Traderz: You can
makealotofmoney,butyou
really owe it to yourself to
educate
yourself
first;
otherwise you risk losing
everything. When you trade
options, there are also
commissions to consider.
Except for day trading, stock
trading normally involves
holding onto winning trades
and only selling when a stop
loss gets tripped or a
technical indicator points
towards a reversal. But with
options,youcanstartracking
upcommissionsandfeesvery
quickly, especially if you
trade weekly options. If you
are selling a Covered Call
because you are bullish on a
stock, and you are correct,
you will end up paying three
commissions: one to buy the
stock,onetoselltheCall,and
another when the Call is
assigned. Some brokers
charge inflated commissions
for exercise, so you might
end up paying the equivalent
of four commissions. But the
samepositionopenedusinga
Naked Put would only incur
one commission, the one to
sell the Put, which would
thenexpireworthless.
Stock Trader: I really
admirethepatienceyouhave
withRookie.
OptionzTraderz:Iwasonce
arookietoo.Ifheisgoingto
failasatrader,atleastIwill
haveaclearconsciencethatit
wasn’tmyfault.
Stock Trader: Now that I
think about it, Naked Calls
might actually be a better fit
for my trend trading. When I
trendtradewithstocks,Ilike
tobuywhenpricesaregoing
up,notdown.IfIsoldNaked
Calls at a resistance level, I
couldthenbuytheunderlying
sharesifmystrikewashit.
Optionz Traderz: That is
also a good plan. You could
also consider selling Naked
Calls at a moving average.
Just as an example, if you
soldCallsoneweekout,you
might want to use a 20-day
moving average as a strike
price, and then buy the
underlyingsharesiftheprice
hit the moving average. Not
only would you be buying
when prices were on their
way up, but you would have
some downside protection
againstwhipsaw.
Stock Trader: I’ve always
consideredNakedCallstobe
too risky. Doesn’t the risk of
unlimitedlossesoutweighthe
incometheygenerate?
Optionz Traderz: It is true
that losses are theoretically
unlimited. But try thinking
about it this way. How often
do you see the Dow Jones
rise 500 points in a week?
Compare that to the number
of times the index has fallen
bythatamount.
StockTrader:That’sanother
greatpoint.Ireadsomewhere
that prices ordinarily fall
twiceasfastastheyrise.That
means I should have many
more opportunities to hedge
my trade if prices started
climbing towards my strike
onaNakedCallthanIwould
to control my losses on a
NakedPut.
Optionz Traderz: Exactly!
Even though the risk on a
Naked Put is limited to the
maximum loss that would be
sustained if the stock price
wenttozero,thelikelihoodof
a Naked Put trade quickly
going bad is much higher
than a Naked Call doing the
same.EvenifyousellNaked
Calls around news events,
such as right before an
earnings announcement, the
collapseofvolatilityafterthe
announcement will likely
limit your losses if the
announcement happens to
surprise investors with great
news. On the other hand, if
you sell Naked Puts prior to
earnings and the news is
disappointing, the increase in
Implied Volatility could
causeyoutolosemoneyvery
fast, as the options are not
only increasing in intrinsic
valuebutalsopickinguptime
valueduetoVega.
Stock Trader: I never
thought of it like that before.
Given the same amount of
changeinthepriceofastock,
Naked Calls don’t lose
money as fast as Naked Puts
because volatility usually
dropswhenpricesarerising.
Optionz Traderz: Yes, and
whenyoulookatitthatway,
Naked Calls are actually less
risky than Naked Puts,
despite
the
theoretical
possibility of unlimited risk.
This is especially true on
ETFs where diversification
makesasuddenupwardmove
lesslikelythanitwouldbeon
an individual stock. And you
always have the option of
buying a Call at a higher
striketoprotectyoufromthe
occasional
takeover
announcement or some other
news release that suddenly
sends the stock soaring. Say
you decided to sell Naked
Calls on Apple at the $450
strike; you might be able to
buy Calls at the $500 strike
for $1.00, essentially turning
the position into a Vertical
Spread.
StockTrader:That’sagood
idea. I would limit my
potential profit, but I would
have some added protection
in case the stock really took
off. So I could tie my Naked
option selling into my stock
trading, selling Puts when I
am bullish and Calls when I
am bearish? Sell Puts on
market leaders and Calls on
market laggards? Sort of just
overlay option selling on my
pre-existing
profitable
systems?
Optionz Traderz: Those are
all good strategies. Many
people sell options for a
living. The secret to
successfullysellingoptionsis
to not get greedy and oversell, and also to manage the
biglosseswhentheybeginto
occur. That is another reason
that option sellers have an
advantageoveroptionbuyers.
Sellers can manage their
losses, sometimes even
turning losses into gains, but
theonlychoiceforabuyeris
tocutlosses.
Whenyoubuyanoptionand
it expires worthless, it is
dead, that is the end. But
whenyousellanoptionandit
ends up in an unfavorable
position, there will be times
whenyoucanbringitbackto
life.Justaswediscussedwith
CoveredCalls,whenaNaked
Put trade starts to go the
wrong way, you can either
rolltheoptionsouttoalower
strikeorkeepthesamestrike
and roll them out with a
lowernumberofcontracts.
StockTrader:Iwouldhave
never thought of it that way.
IfIbuyoptions,Ireallyhave
norecoursewhenatradegoes
bad except to watch them
slowlydieorputthemoutof
their misery early. If I sell
optionsandtheygodownthe
wrongpath,Iwillsometimes
get the chance to keep them
aliveforanothermonthorso,
giving them a second chance
at living a prosperous life.
Whatotherconsiderations?
Optionz Traderz: It’s up to
every option trader to decide
how much risk is too much.
The potential reward is
always proportional to the
amountofrisk.Atraderwho
hasneverownedApplemight
be more comfortable with a
Put Spread, while a trader
who bought shares of Apple
when it was trading at $200
might feel more comfortable
riskingthosegainsbyselling
his shares at $400 and then
Selling Naked Puts. Option
tradingisveryflexible.
Stock Trader: I agree with
youagain.Ihavetochoosea
trade that makes me
comfortable so I won’t be
tempted to allow my
emotions to influence my
decisions.Anyotherideas?
OptionzTraderz:Ihavemet
some traders that sell Naked
Puts and Calls at the same
time. Many times, both
options expire worthless and
theygetdoubleprofits.
Stock Trader: But aren’t
they taking double the
amountofrisk?
Optionz Traderz: At first
glance it might appear that
way.Butinthelongrun,that
riskisoffsetbecausetheyare
also collecting double the
amount of premiums. One of
theoptionswillalwaysexpire
worthless, and over time that
will eventually offset the
lossesontheotheroption.
StockTrader:Sohowwould
I manage a trade involving
bothNakedCallsandPuts?
OptionzTraderz:Therewill
betimeswhentheunderlying
price starts to move against
one of your positions. In
those cases, you have lots of
choices to manage the trade.
Sometimes it is possible to
take the profits on the
winning position and roll the
losing position to a more
favorable strike. Other times,
ifthepriceisnottoocloseto
overtaking one of the strike
prices, it might be better to
turnthewinningpositioninto
aSpread.
Let’s say you sold $350 Puts
and $450 Calls on Apple,
each at $3.00, and the price
suddenly shot up from $400
to $410. You should then be
able to buy a $360 Put for
$3.00, in effect turning that
side of the trade into a ‘free’
Put Spread. You’d still have
$40 of play before the price
hit your Naked Call strike;
but if the price whipsawed,
the Put Spread could see
somenicegains.
There are times when the
pricewhipsawsenoughthatit
is possible to turn both sides
ofthetradeintoSpreads.Say
the price moved again, but
thistimefellfrom$410back
to $390; you would then be
abletobuythe$340Callsfor
$3.00. The good news is that
neither Spread would cost
you anything because you
would be opening the long
position at a time when the
premium was less than, or
equal to, the premium you
receivedontheshortposition.
If either Spread realized its
full potential, you would see
aprofitof$10pershare,and
at the very worst, everything
wouldexpireworthless.
Stock Trader: Those sound
like great ways to manage
risk. I guess I would also
havetheoptionofrollingthe
Naked Calls out, if I turned
theNakedPutintoaVertical
Spread and the underlying
price continued in a steady
uptrend that placed it in
danger of reaching my Call
strike.Anymorethoughts?
Optionz Traderz: Once
again I will reiterate position
sizing.Ifyouarecomfortable
trading no more than 200
shares of a stock, then only
sell2contractsofthePutsor
Calls short. Do not suddenly
start selling 20 contracts of
NakedPutsjustbecauseyour
marginrequirementsallowit.
You would be asking for
trouble when that one
unexpected event occurred,
and those events occur more
often they you would expect.
Even if you manage to make
it ten years without a Black
Swan,ifyourpositionsizeis
toolarge,youcouldwipeout
yourentireaccount,including
those ten years of profits,
veryquickly.
Stock Trader: There is
nowheretohidefromcorrect
positionsizing.
Optionz Traderz: Many
traderswhoselloptionsfora
living sell Naked Puts for
stocksthattheywanttoown.
For example, if a trader
wantedtobelong200shares
of Apple and wanted to buy
in at the 200-day moving
average, he could repeatedly
sell 2 contracts of Puts each
month.Soifittook6months
to get the stock put on him,
he would make about $600 a
month selling Puts, and he
would see $3,600 in profits
beforehefinallygotthestock
at the price he wanted. The
$3,600 profits would reduce
the cost basis of the 200
shares of stock by $18 a
share, and they likely would
then go on to make capital
gains in the stock itself, after
itwasputonhimathiswish
price.Eveniftheydidnot,he
wouldbeinapositiontouse
a very generous stop loss
order.
Stock Trader: I guess
another scenario would be if
the Naked Puts went in-themoney the first month. He
couldrollthemdownandout
to the following month and
keep doing that until there
were no more options with
sufficient premiums to cover
the loss on the previous
month’s Puts, at which point
he could allow the shares to
be put on him at a nice
discount, and then wait for
thestocktorebound.
Optionz Traderz: Yes, that
would be a good choice in
some circumstances, where
the company was still strong
but had just hit a soft patch,
or when the price was being
weigheddowntemporarilyby
thebroadermarket.Butother
times, when chances for the
price to recover are in
question, it would probably
bebettertocutthelossesand
move onto something more
promising.
Stock Trader: Great advice,
asalways.
Optionz Traderz: I know
some traders that also use
options as an indicator to
predict whether a stock price
isheadedupordown.
Stock Trader: How is that
possible?Aren’ttheoddsofa
stock going up or down in
pricealwaysequal?
Optionz Traderz: Actually,
the odds of a diversified
portfolio
of
stocks
experiencing
upward
movement are historically
slightly higher than the
chances of prices falling.
Even when markets are
stagnant, inflation usually
addssomeupwardpressure.
StockTrader:O.K.,soeven
if prices normally rise over
the long term, how would
options help me predict what
was going to happen in the
future?
Optionz Traderz: Well, the
stock market is efficient, but
the options market is superefficient. While the prices of
stocks are determined by all
ofthecombinedsentimentof
investors and institutions all
over the world, they only
represent the value at which
buyersandsellersarewilling
tosettleatasinglemomentin
time. In contrast, the
premiumsofoptionstakeinto
account an extra layer of
information, the performance
ofthestockoveranextended
period of time. Options,
because more information is
requiredinordertodetermine
a fair price, are much more
sensitivetonewsandchanges
in the market than stocks;
options actually help drive
stockprices.
StockTrader:O.K.,Ifollow
yousofar.
Optionz Traderz: So some
traders find it useful to study
a stock’s options before they
actually trade shares of that
stock.Optionsthemselvesare
a sort of technical indicator,
andtheycanbeusednotonly
totradestocksbutoptionsas
well. Just as an example, if
there is a large amount of
openinterestinCallcontracts
comparedtoPuts,themarket
is indicating a bullish
sentimentonthatstock.Ifthe
underlyingpricedoesstartto
moveup,thelargenumberof
Call options can help give it
momentum. As the price
rises, Call buyers are more
likely to exercise their
contracts, which results in
increasing demand for the
underlying shares. At the
same time, Call sellers are
more likely to buy shares in
ordertolimittheirlosses.
StockTrader:Wow!Thatis
areallygoodobservation.I’m
assuming it works the same
waywithPuts.Whenthereis
amuchlargeramountofopen
interestinPuts,thoseoptions
could actually help reduce
demand for the stock if the
price starts to fall, which
would only exacerbate the
dropinprice.IfIamgoingto
sell Naked Puts, I should
probably check the Put/Call
ratiofirst,toseeifthemarket
is predicting bearish days
ahead.
Optionz Traderz: Exactly!
Implied Volatility is another
indicator that you can use to
your advantage. Volatility
normally rises fairly quickly
when prices fall, and then
drops much more slowly
when they recover. If prices
are rising, you might choose
towaitforvolatilitytofallto
a predetermined level before
you decide to sell Naked
Puts, even though you will
receiveasmallerpremium,to
ensure that you are in
agreementwiththesentiment
oftherestofthemarket.
Stock Trader: I see what
you’re saying. If volatility
suddenly went from 30% to
50%,Icouldconsiderholding
off on selling Naked Puts,
evenifthestockwasshowing
signs of strength because the
options market would be
providing evidence of some
uncertainty about the price
continuingtoclimb.
Optionz Traderz: There are
other ways you can use
ImpliedVolatilitytohelpyou
trade. You know that graph I
sent you that showed a
VolatilitySmirk?Well,some
traders have found that the
steeperthesidesofthesmirk
are, the worse the stock will
perform. Sometimes this bad
performance continues for
weeks or even months after
theseoptionsexpire.
Stock Trader: That sounds
confusing. I thought I
understoodImpliedVolatility
asbeingasortofmeasureof
fear. When volatility is high,
it means traders are more
worried that prices will fall.
But why would lower
volatility at-the-money be a
predictorofchange?
Optionz Traderz: I have
seen studies showing that a
persistent smirk is often
present on many widely
tradedoptions,sometimesfor
months,beforeaBlackSwan
event. When a normal graph
ofImpliedVolatilitystartsto
take on a smirk-like
appearance, it could mean
that traders are anticipating
violent price swings in that
particularstock.
The best stock options to
purchaseifyouwanttoprofit
fromabigpriceincreaseina
stock are deep-in-the-money
options. These options are
already profitable with a
strikepricebelowthecurrent
market price, so they already
containintrinsicvalue.These
deep-in-the-money options
move closer in value dollar
fordollarthanfarout-of-the-
money options since far-outof-the-money options have a
low probability of expiring
with any intrinsic value.
Higher than normal demand
for
deep
in-the-money
options can sometimes be an
indicator that speculators are
anticipating a major change
inthestockprice.
If far out-of-the-money
options start increasing in
price more than they should,
based on the Delta of the
option,thisisalsoacluethat
traders are anticipating a big
moveintheunderlyingstock.
Just as with deep in-themoney options, speculators
often control the demand for
farout-of-the-moneyoptions.
You may want to think of
such a smirk as a warning
signthatitmightnotbesuch
a great environment for
selling Naked Options.
Instead you might want to
consider that with at-themoney
options
being
relatively cheap compared to
thoseatotherstrikes,itmight
beabettertimetouseaLong
StraddleorStrangleinstead.
Stock Trader: That is
fascinating. You’ve been
reallyhelpful,butIthinkI’m
goingtohavetotakeabreak
and digest some of this. I
guess if I can use options to
help me predict the future
price of a stock, they would
also help me choose what
optionstouseifIamgoingto
sellNakedones.
Optionz Traderz: You’ve
got it! Studying all of the
options on a particular stock
can give you additional
information you would not
get from a traditional
fundamental and technical
analysis. That additional
information may prove
helpful in deciding what and
when to trade, whether it is
stocks or options or both.
Speculation is much more
profitablewithoptionsthanit
iswithstocksduetothelarge
amount of leverage they
provide. As a result,
speculation often causes
optionpricingtochangelong
before the stock makes any
significantmoves.Beforeyou
placeanytrade,youshouldat
least look up option tables to
find out what kind of
speculationisoccurring,even
if it is just for a second
opiniontobackupyourother
technicalindicators.
Stock Trader: You are full
of good ideas tonight. Well,
it’s been nice chatting with
you.I’llneedtostudyNaked
Calls a little more to see if
they will work for me, but I
really like the idea of Naked
Puts, of being able to choose
the prices I pay for my
favorite stocks and get paid
forbuyingthem.
Rookie Trader: Now if that
isnottheHolyGrail,Idonot
knowwhatis.Yougetpaidto
buy a stock at your dream
price?Soyoueitherkeepthe
premiums or get the best
priceforahotstock.Howdo
youlose?
Optionz
Traderz:
Easy.
Apple continues to fall by
50% after it falls through the
200-daymovingaverage,just
likeitdidbackin2009.You
needtofollowupthatsystem
with a stop loss on the stock
itself, after it is put on you,
andyouneedtokeepinmind
thatitcouldbeputonyouat
a price that is already
significantly higher than the
priceatwhichitistradingon
expiration day. There are no
free rides in the market, and
once again, no Holy Grails.
Anythingcanhappen,soyou
havetoalwaysbeready.
Stock Trader: As always,
amazing food for thought.
Youmusttradealotorreada
lottoknowalot.Youhavea
goodnight.
Optionz Traderz: Options
are my business. Good night
toyoutoo.
Rookie Trader: Finding the
Holy Grail in trading is my
business.
PennyPumper:Hey,Rookie
Trader, I can help you find
theHolyGrail.Justcheckout
EXTO. I read a closely
guarded report this afternoon
which indicates that some
sources are saying there will
be a huge announcement
tomorrowmorningthatcould
sendthisstockupover800%.
Butifyouwanttogetin,you
should consider doing it
early, before the big-time
traders scoop up the
remainingshares.
Rookie Trader: 800%, of
course I’m interested. I’ll be
up first thing in the morning.
Then wait till I show Stock
Trader and Optionz Traderz
howwellarookiecando!!!
Penny Pumper: If you give
me your email address, I’ll
sendyouacopyofthereport.
Rookie Trader: I’m sending
my address to you now. I
better get to bed, though. I
don’t want to oversleep and
miss out on an opportunity
like this. Thanks for helping
meout.
Penny Pumper: Great to
hear it. I know I’ll be
watching EXTO first thing
tomorrow.
Chapter9
BUYING
LOTTERY
TICKETS:
DEEPOUTOF
THEMONEY
OPTIONS
Saturday... Relaxing,
peaceful, and B-O-R-I-N-G;
whattodo?
Stock Trader found
himself in his favorite book
store, perusing the little
investingsection.Hewasnot
impressed.
He sat at one of the
small, sticky tables with his
favorite energy drink and a
chart of his favorite stock –
his beloved Apple. He loved
his iPhone, his iPad, and his
Macintosh, along with the
money the stock had made
him over the years. He could
have bought a few nice cars
withhistradingprofits.
Charts
courtesy
of
FreeStockCharts.com
Stock Trader liked to
view stock charts with the
Bollinger Bands and moving
averages.
In his stock trading
method,
the
Bands
established a logical trading
range of two standard
deviations with the 20-day
moving average as the mean
value. The 50-day moving
average was the first stop of
support for a hot stock and
the 200-day moving average
was the final place where
buyers would come in and
buy a hot stock at a bargain.
Thiswashisprimarysystem.
Nowthequestionwas:
“How can I use my
stock trading methods to
profit the most from trading
options?” He felt a sense of
déjàvu.
Hestaredatthechart;
it was making a new run at
all-timehighs.Woulditbreak
out?Hedidn’tthinktheprice
basewaslongenoughyet,but
he could be wrong. Apple
wasapowerfulstockthatwas
known to climb up a
Bollingerbandlikeamonkey
upatree.
His next thought was,
ofcourse,howtotradeitwith
options.
Hewroteonapieceof
papernexttohisiPad:
1)At-the-moneyCalls
2)
Puts
Out-of-the-money
He thought the two
best trades would be to buy
Callsnow,at-the-money,and
if the breakout to all-time
highshappenedandthestock
rocketed up to a whole new
trading range, he would do
verywell.Hewouldhavehis
Calls at what should be the
new support, at the level of
the price breakout. However
ifthebreakoutfailedhecould
losemostorallofhiscapital
as the stock moved back to
the50-daymovingaverage.
Hisotherthoughtwas
tobetthiswasresistanceand
buy Puts at the price level of
the current 50-day moving
average. The probabilities
weregoodthatifthebreakout
failed, the price would go
back to test that level. It
would require less capital to
betonaretest.
Apple was trading in
at$422.
Dec. $420.00 Calls
were$26.00acontract.
Dec. $385.00 Puts
were$12.00acontract.
“Wow,”hethought,“I
would need either a quick
move up or down in either
direction, while the options
stillheldtheirtimevalue,ora
move to $446 by December
fortheCallstobreakeven,or
adownmoveto$373forthe
Puts to break even. These
options are definitely priced
efficiently to break even
basedonexpectedmoves.”
How could he get the
oddsbackinhisfavor?
He was deep in
thought, watching the barista
inthebookstore’scoffeeshop
efficiently
waiting
on
customers.
Stock
thinking.
Trader
was
Besides the coffee
shop franchise, the store was
really empty, customers
having migrated to online
booksellers for reviews and
better pricing. A couple of
touches to his iPad and he
was looking at the chart for
Amazon.com.
Charts
courtesy
of
FreeStockCharts.com
“I wonder if hot
stocks in up trends would be
the best underlying stock to
useforoptionbets.”
Now that I know the
dangers of selling lottery
tickets, I wonder how I can
get on the winning side of
buying lottery tickets, with
theoddsslightlyinmyfavor.
“IbetbothAppleand
Amazon made some option
buyersbigwinnerswhenthey
bought
out-of-the-money
Calls, betting that the stocks
wouldnotrolloveranddieat
the 50-day or 200-day
moving average just because
the market was in a
downtrend. These were
market leaders, companies
with
growing
earnings
dominatingtheirsectors;they
came back with a fury when
the market as a whole
returned to an uptrend,” he
thought.
“Itistimetosendout
the signal and call the Bat
Phone.”
Stock Trader got
home,andasalways,wentto
hisdesignatedcomputerspot.
He was lucky. Optionz was
online.
Stock Trader: You may
need to go to Social
NetworkersAnonymous.
Optionz Traderz: Look
who’s talking, ‘Mr. Social
Networking at Midnight’
himself.
StockTrader:LOL.
Optionz Traderz: What are
youuptotoday?
StockTrader:Ijustgotback
from the book store ghost
town.
Optionz
Traderz:
Tumbleweedsintheaisles?
Stock Trader: Yep, but in
thecoffeeshopIwaslooking
atafewchartsofmyfavorite
stocks, AAPL and AMZN,
and wondered what the best
way to buy lottery tickets on
them would be. With the
dangers of selling out-of-themoney options in mind, I
wonderedhowIcouldflipthe
odds more in my favor if I
bought them. I spend a little
andthesellerrisksalot.Ilike
the risk/reward ratio, just not
the odds. What are your
thoughts?
Optionz Traderz: You just
never stop, do you? You are
like an option vampire,
alwaysthirstyformore.LOL.
That'sO.K.,though,metoo.
O.K., if you want to buy an
out-of-the-money option I
would follow
principles:
a
few
1. The underlying price
normally remains within
a range of one standard
deviation about twothirds of the time. A
quick way of estimating
this range is to look at
thestrikepricesofCalls
with a Delta near 0.8 or
0.2.Anyoptionsoutside
of this range represent a
stock price that is
outside of the market’s
consensus of what that
price will be at the
expiration
of
the
contract; they truly are
‘lottery tickets.’ When
you buy a lottery ticket,
youareacontrarian,you
are betting against the
odds. It's O.K. to bet
againsttheodds,butyou
needagoodreasontodo
so.
2. Do not go too far out
in price; ideally you
want a price that the
stockhasbeentobefore,
the all-time high for a
Call or the last major
support level for a Put.
That gives you better
odds of the stock
actually getting back
there.
3. Give yourself enough
time. You may need to
spendtheextramoneyto
go at least three months
out; the odds are much
better for you if you get
more than 60 trading
days to be right instead
of just 20. The farther
out you go, the more
randompricesbecomein
thefuture,andthebetter
value you get for the
time value of your
option on the ‘buy’ side
because
of
this
uncertainty.
4. You need to buy the
options on a stock that
hasthepotentialtomake
the big move and get
whereyouarebettingon
it going. Of course, the
price premium will be
higher if it is volatile;
butyouneedastockthat
has the potential to
move, not an old tired
blue chip that has its
price move as if it were
trudging through mud.
Youdon’tneedtoavoid
low-volatility
stocks
entirely, but the chances
for a big win are much
better with companies
that have a potential for
explosive
earnings
growth.
StockTrader:SoanoldalltimehighmaybeagoodCall
optiontobuywhenthestock
is down at a support level,
and an old support may be a
good place for a Naked Put
when a stock is at all-time
highs?
Optionz Traderz: Yes, outof-the-moneyoptionsarebest
played by being a swing
trader or a contrarian. I think
it is much more difficult to
betonanewall-timehighor
low, places where the stock
pricehasneverbeenbeforeor
at least not in a long time.
Investorshavememories,and
old levels cause exits and
entries from the current
holders of the stock and also
from the traders waiting on
thesideline.Manytimes,new
pricelevelscreatewholenew
patterns that are hard to
predict.
StockTrader:O.K.,soright
nowAppleisat$422.Would
it be a good play to sell a
December$385Put?Thatis
very close to the 50-day
movingaverageandtheDelta
is0.25?
Optionz Traderz: How
manytimeshasAAPLhitthe
50-daymovingaverageinthe
pastthreemonths?
Stock Trader: Let me
look…four times. That looks
likeagoodbet!
OptionzTraderz:Holdyour
horses! What was the
differenceinthepricelevelof
the50-dayfromthreemonths
agountiltoday?
Stock Trader: The 50-day
was at $338 in July when it
touchedthatlevel,anditwas
at $380 in October, the last
time it bounced most
recently.
Optionz Traderz: It is a
movingtargetwhenthestock
is in such an uptrend. By the
time it touches again, it may
be at $410; that is what the
chartistellingyou.
Stock Trader: Well, that
seemsveryobvious,nowthat
youpointeditout.
Optionz Traderz: If you
were trading the shares, how
wouldyoutradethem?
StockTrader:Well,Iwould
buy them as they either
bounced at the 50-day
moving average or went
underitandretookit.Iwould
sell after they broke out and
found support at a new price
level, which would likely be
atthebreakoutpoint.
Optionz Traderz: Then that
is probably your best option
play.YousellaCoveredCall
with a strike at the likely
breakout point, when the
stockfindssupportatthe50daymovingaverage.
Stock Trader: I was hoping
to find some way to buy
options instead of selling
them and without needing to
purchase the underlying
shares.
Optionz Traderz: Well, I
was going to suggest you
might try selling a Put at the
50-day moving average and
also a Call at the current
resistancelevel,butifyouare
interested exclusively in
buying options, I think I can
help.
StockTrader:I’mlistening.
Optionz Traderz: O.K.. It
would probably be easier to
focus your trade on the alltime high instead of the 50day moving average. The
high is not a moving target
like the moving average is.
Buying Calls at a strike near
the all-time high would be
one strategy. They are far
enoughout-of-the-moneythat
the premiums are reasonable,
but they are at a strike price
that the stock has proven it
has the ability to achieve.
You may lose on a few of
these trades, but when the
stock breaks out after an
earnings announcement or in
the run up to the earnings,
youcouldmakeahugereturn
onyourcapitalatrisk.Weare
talking 100%-400% or more
returns on out-of-the-money
Callsin3months,withoneof
thosewild$75runslikeithas
madeinthepast.
Penny
Pumper:
Hey,
Optionz Traderz and Stock
Trader, 100% is not enough
of a return! I can help you
find the Holy Grail. Just
check out EXTO. I read a
closely guarded report this
afternoonwhichindicatesthat
somesourcesaresayingthere
willbeahugeannouncement
tomorrowmorningthatcould
sendthisstockupover800%.
Butifyouwanttogetin,you
should consider doing it
early, before the big-time
traders scoop up the
remainingshares.
Stock Trader and
Optionz
Traderz
simultaneously pushed the
block button for Penny
Pumper and then both
wondered why they didn’t do
so sooner; but neither one
knewtheotherhaddoneso.
Stock Trader: But if Apple
doesn’tbreakout,Iloseitall.
Optionz Traderz: Not
necessarily. If you were
trading
three-month-out
optionsandamonthwentby
without any price movement,
you would have alternatives.
If you remained confident
about a breakout and the
options were liquid enough,
you could roll them to the
following month and might
beabletokeep50%ormore
ofyourcapitalintact,aslong
as the stock had not moved
wildlyagainstyou.Duetothe
acceleration of time decay,
rolling during the last month
before expiration would cost
you much more, but you
couldstillbenefitnicelyifthe
breakoutfinallyhappened.
Stock Trader: So I would
stillhaveachancetoprofitif
thestockdidbreakout,butI
wouldbebuyingmyselfmore
timeforthattooccur?
OptionzTraderz:Yes,andit
works the same way when
you end up with a winner.
Sometimes, if it is the ‘big
win’ and it is in-the-money,
you may want to let it run
into the final month and
capturesomehugeDeltathat
will easily pay for the lost
Theta.
Stock Trader: But wouldn’t
I be giving up a lot of my
potential profit by allowing
Theta to take away some of
thevalue?
Optionz Traderz: LOL,
slow down; you’re learning
faster than I can type! I was
justgettingtothat.Whenyou
buyoptions,itislikeyouare
buying insurance. If you buy
automobile insurance and the
car subsequently gets totaled
in an accident, there is little
reasontocontinuepayingthe
premium. You take your
payment from the insurance
companyandyoumoveon.
StockTrader:Sooptionsare
likeinsurancepolicies?
Optionz Traderz: You’ve
gotitexactly.Everybuyerof
an option is purchasing
insurance; that’s one reason
why the price is called a
premium. Every option
provides two types of
protection, one against rising
pricesandoneagainstfalling
prices.
Stock Trader: Wait, how
could buying a Call protect
mefromfallingprices?
Optionz
Traderz:
Technically, it wouldn’t, but
I’mcomparingoptiontrading
to stock trading. If you are
buyingCalls,itismostlikely
becauseyouareattemptingto
use options as a replacement
for buying stocks. So
compared to buying stocks,
Calls give you insurance
against rising prices as well
asfallingprices.Calloptions
do provide a limited
downside in that the risk is
only in the price of the
contract, not the full price of
the100sharesofstock.
Stock Trader: So how do I
know when to cancel the
policy?
Optionz Traderz: You
cancelitwhenitisnolonger
necessary, just like canceling
yourautoinsurancepolicy.If
youaredrivingabeat-upold
truck, there is no reason to
keep paying premiums on a
policy that protects against
theft.Atsomepointyouneed
to accept that all those
premiums you paid over the
years were wasted; you got
peaceofmind,butyourtruck
was never stolen. When you
find yourself driving a truck
that nobody in their right
mind would ever steal, it’s
time to cancel the theft
insurance.
Stock Trader: O.K., this is
getting a little abstract, but
youranalogieshavenotfailed
inthepast,sogoon.
Optionz Traderz: I’m glad
you like my analogies. I find
they are the best way to
understand options. So, let’s
sayyouboughtthoseCallson
Apple at the all-time high,
whenitwastradingatthe50day average. Then, assume
the price fell through the
averageanddidnotretakeit.
Nowyouaredrivingthebeat
up old truck. The ‘insurance
company,’ the Call seller,
would love for you to keep
paying the premium for the
lengthofthecontract,butthe
insurance is no longer
necessary. The risk you were
insuring
against,
the
possibility that the stock
would surpass its all-time
high, would be almost nonexistent. That is the time to
cancel, either by selling the
Callsorrollingthem.Ishould
pointoutthatitisnotalways
necessary to sell Calls that
have little chance of being
profitable. It usually makes
sense to do so on a high
priced stock like Apple,
wheresellingearlymightcut
yourlosssignificantly.Buton
low priced stocks with low
priced options, it often isn’t
worththeeffort.
Stock Trader: I see what
you’resaying.Butwhatabout
when the price rises and the
optionsgoin-the-money?
Optionz Traderz: That
would be the equivalent of
crashingyourtruck.
Stock Trader: Now I’m
confused. If I buy an out-ofthe-money Call and the
underlyingpricesurpassesthe
strike,isn’tthatagoodthing?
OptionzTraderz:Ifyoubuy
an option and it goes in-themoney, the event for which
you purchased the insurance
protection
has
already
occurred. That is the point
where you need to ask
yourself if the insurance is
still necessary. If you bought
those Calls on Apple and the
stock broke through its alltime high, they would have
served their purpose. At that
time you would need to reevaluate the upside potential
oftheshareprice.Ifthestock
hadhitresistance,thetruckis
totaled; it’s time to take the
money and go buy a new
vehicle. If the stock was still
climbing, you would have to
ask yourself whether it was
worthwhile to continue
paying the premium. If the
amount of time value
remaining on the Calls was
small,itmightmakesenseto
keep the trade open. But if
there was a large amount of
timevalueremaining,itcould
make more sense to just sell
the Calls and buy the
underlyingshares.
Stock Trader: That makes
perfect sense. Why keep
paying the premium if my
indications were that the
stockwasheadedup?Icould
do much better by simply
buyingtheshares.
Optionz Traderz: Exactly.
And it works the same way
with Puts. Say you bought a
stockandalsopurchasedoutof-the-money
Puts
as
protection. Once the stock
falls through the strike price,
thetradecanonlylosemoney
overtime,aslongasthestock
never rises above that price.
At that moment, you would
either believe the stock was
onitswaybackup,inwhich
casethePutswouldnolonger
benecessary,orthestockwas
not going to retake the level
of the strike price, in which
case the entire trade should
probablybeclosed.
Stock Trader: So I guess
that’s why early exercise
doesn’t make sense. If I
bought a Put for protection
and it went in-the-money, I
would lose all of the
remaining time value if I
chose to exercise it early.
And if I held on through
expiration, I would also lose
all of the remaining time
value. However, if I sold the
Putandtheunderlyingshares
as soon as the Put went inthe-money, I would cut my
loss by the amount of time
valueremaining.
Optionz Traderz: You
naileditagain!Earlyexercise
almost never makes sense;
the only reasons to do so are
usually associated with
capturingdividendsortoalter
the tax liability. When you
buy an option and it ends up
in-the-money, you need to
ask yourself, “Would I
exercisethisoptionearly?”If
theanswerisno,youneedto
immediately
consider
whether it makes sense to
keep that trade open. If you
bought those Calls on Apple
and the shares suddenly hit
theirall-timehigh,wouldyou
exercisethemearly?
StockTrader:Ofcoursenot,
becauseIwouldbelosingall
of the remaining time value;
and because I had picked a
winner,Iwouldbehopingto
letitrun.
Optionz Traderz: But if it
really was a winner and you
did let it run, it would
performexactlythesameasif
youhadexerciseditearly.
Stock Trader: I never
thoughtofitthatwaybefore.
Whenthestrikepriceishiton
anout-of-the-moneyCallthat
I own, it really is like a car
accident. The only reason to
keep the Call as insurance
against
further
upside
movementisiftheremaining
time premium is low enough
to justify the downside
protection.
OptionzTraderz: Whenever
you own an option that ends
upin-the-money,youneedto
re-evaluate the position so
thatyoucanletyourwinners
reachtheirfullpotential.The
same concept applies when
you own an option that ends
up losing money. At some
point, the cost of the
insurance will often be
unjustifiable for the amount
ofprotectionitprovides.That
is the time to cancel it, and
that is the basis of all
successful trading: increasing
your profits and decreasing
yourlosses.
Stock Trader: Hmm, letting
winnersrunandcuttinglosers
shortthatsoundsfamiliar.
OptionzTraderz:Tradingis
trading,inallitsforms;some
rules are universal. And you
should keep an open mind
about selling options as well
asbuying.BuyingCallsatthe
all-time high on Apple when
thestockishotcouldbevery
profitable, but that trade is
based only on that particular
stockandchart.Withastock
in a nasty downtrend, you
may have to reverse it and
sell Puts at the all-time low,
whenthestockralliesandhits
resistance at the 50-day
movingaverage.
StockTrader: I really never
thought of trading options
like this. Another interesting
system for me to think
about…
Optionz Traderz: You
shouldn’t limit yourself to
just one strategy. Buying
Callscanworkverywellina
bull market, and so can the
selling of Puts. Naked Puts
are just another way to put
the odds in your favor – bet
that a hot stock is not dead
and will rise again to an alltime high. When you get the
rare opportunity that one of
these monster stocks goes all
the way to the 200-day
moving average, after the
Puts you sold caused you to
buyinattheall-timelow,you
couldmakeakilling.
StockTrader:Aslongasthe
market stays in an overall
bullishtrendandthesestocks
stayasleaders,thesesystems
willwork.
Optionz Traderz: That is
true.Thesesystemsworkbest
inbullmarkets,andthereare
otheroptionssystemsthatare
tailored for every other type
ofmarket.
Rookie Trader: If there are
options systems for every
type of market, that truly is
theHolyGrail.
Optionz
Traderz:
ATTENTION,
Rookie
Trader. This is not the Holy
Grail!
RookieTrader:Darn.
Optionz Traderz: I say it is
not the Holy Grail because
there are hidden risks for
every one of those systems.
For example, if you are
buying
out-of-the-money
Calls in a bull market, you
shouldkeepinmindthatCall
options usually become
cheaper as stocks begin to
trend upward. As fear
dissipates from the market,
Implied Volatility decreases.
The decrease in volatility
causes all options to lose
some of their time value,
sometimes to such a degree
that it overshadows the
increasing probability that
they will end up expiring inthe-money.Whenyoubuyfar
out-of-the-money Calls, you
need to be prepared for
occasions
when
the
underlying price increases
significantly
while
the
premium on those options
actuallydecreases.
StockTrader:SoIguessifI
buyout-of-the-moneyCalls,I
should be looking for returns
only in intrinsic value,
because Theta and Vega are
both working to take away
muchoftheirtimevalue.
Optionz Traderz: Correct.
The reason that out-of-themoney options are relatively
cheap is that they expire
worthless most of the time.
Even when a trend does
materialize, it often takes so
muchtimefortheunderlying
to reach the strike price that
Theta removes much of the
time value. When you buy
options, try to think of the
premiumasthecostofdoing
business; whatever amount
you spend will probably be
totally lost to Theta and
Vega. The only money you
will make will likely be in
intrinsicvalue.
Stock Trader: That is an
interestingwaytothinkabout
it. Buying out-of-the-money
options really is like buying
lottery tickets; even if I win
the lottery, the seller gets to
keep the original cost of the
ticket.
Optionz Traderz: Again,
that is another reason for the
perception that sellers have
an advantage over buyers.
Even when everything goes
right for the buyer, the seller
usually keeps most, if not all
oftheoriginalpremium.
Stock
Trader:
Your
negativity is starting to make
mefeeldepressedagain.
Optionz
Traderz:
As
always, I’m being negative
for a reason. You must
understand the risks involved
before you enter any option
trade. If you understand the
risks, you are much more
likely to be able to protect
yourself. Also, when you
understand the risks you will
belesslikelytobeinfluenced
by emotion. When a trade
doesnotperformasexpected,
itisoftentemptingtocloseit
and take the loss. But if you
know what to expect
beforehand, your decision of
whether or not to close a
trade will be based on your
provensystem,notemotion.
Stock Trader: Point taken.
Are there any other risks to
consider?
Optionz Traderz: Well,you
needtoalwaysrememberthat
the options market is more
efficient than the stock
market. Stock prices only
take into account the
information available to
tradersatasinglemomentin
time. Options prices are
determined not only by
information that is currently
available, but by historical
information, as well as
predictionsaboutinformation
that will be available in the
future.
Stock Trader: O.K., I’m
withyousofar.
OptionzTraderz: Just as an
example, if you were to buy
shares of Apple prior to an
expected
announcement
regarding sales of its latest
iPhone, they would likely be
pricedatalevelthatreflected
the sales estimates of
analysts. When analysts
predict favorable sales, there
is often a run up in price
beforetheannouncementand
occasionally
a
sell-off
afterwards, even when a
company meets or exceeds
theestimates.
Stock Trader: Yes, I have
seen the old ‘Buy the rumor;
Sell the news’ effect on
stocks. What effect would
therebeonoptions?
Optionz Traderz: Option
premiums are based almost
entirely on time and
volatility. Normally, that
volatility is a reflection of a
fear that the underlying price
will fall over time. But
announcements of sales,
earnings,ornewproductscan
cause a different kind of
volatility, a ‘fear’ of rising
prices.SellersofNakedCalls
arevulnerabletoahugerally
occurring if a company
reports
something
that
exceeds
the
market’s
expectations.Asaresult,they
demand higher premiums as
compensation for the added
risk.
Stock Trader: That makes
sense.SoifIamgoingtobuy
Calls, I should check to see
whether there is any
upcomingnewsthatmightbe
inflatingthepremiums.
Optionz Traderz: Exactly.
When you trade stocks, it is
possible to profit using a
purely technical analysis of
indicators such as price,
volume,
and
moving
averages.Butwhenyoutrade
options, you need to
remember that there are also
traders who base their trades
on a fundamental analysis of
a company’s current value
andexpectedfutureearnings.
Option premiums reflect the
combination of both methods
oftrading.
StockTrader:Iwouldnever
have thought of that. If I
boughtanoptionbasedonmy
technical analysis alone, I
would run the risk of the
trade moving unexpectedly if
I did not pay attention to the
way it might be affected by
other traders who were using
a fundamental analysis. I
guess I’ll have to start
looking at the fundamentals
and paying more attention to
the news if I am going to
convert my stock trading
systemtooptions.
Optionz Traderz: That is a
good idea when you are
buying options. When you
sell options, you don’t really
need to do as much research
because the premium on
everyoptionreflectsallofthe
combined sentiment of both
technical and fundamental
traders; you always receive a
fair premium based on the
amountofriskyouaretaking.
That’s not to say that buyers
aren’talsopayingafairprice;
they are. But buyers have
fewer alternatives as far as
managing the trade if it
movesunfavorably,andthose
unfavorable moves could be
caused by fundamental
traders.
Stock Trader: Now you are
startingtomakemethinkthat
buying the out-of-the-money
‘lottery tickets’ is not such a
goodidea.
Optionz Traderz: They
mightortheymightnot;itall
depends on your trading
personality.Basically,itboils
down to this. Option sellers
have peace of mind when
they open a trade because
they are letting the market
predict what is going to
happen. Sure, they might do
some analysis beforehand,
but once they open a trade
they know that they have
received compensation that
was calculated by the
market’s prediction of the
underlying price’s future
movement. Then they can sit
back and relax and simply
reacttothemarketbycutting
their losses when the
market’s prediction was
incorrect.Optionbuyersneed
to be able to predict the
future. When you buy an
option, especially one that is
out-of-the-money, it is like
youaresayingthatyouknow
somethingthemarketdoesn’t
– and maybe you do. If you
have a proven system of
technical trend trading that
works for you, there’s no
reason you can’t apply that
predictive power to a system
of buying options. You just
needtobecarefulyouarenot
ignoring those hidden risks I
described that might not be
uncovered by a
technicalanalysis.
purely
Stock Trader: That makes
mefeelalittlebetter.Iguess
it wouldn’t hurt to do a little
bit of extra research after I
had found a trade that my
system was predicting would
beprofitable.
OptionzTraderz: You can’t
out-wit the options market;
themarketwillalmostalways
win. But there are ways to
make money with options if
you take the time to inform
yourself of any hidden risks.
Ifyouthinkyouhavefounda
good
trade
on
a
pharmaceutical
company,
check for any expected
upcoming regulatory rulings
that might be driving up
Implied Volatility. Likewise,
pendingresolutionoflawsuits
such as those involving
patents can have the same
effect. With stocks, such
events usually get slowly
baked into the share price in
the days and weeks leading
up
to
the
expected
announcement.
With options, the anticipated
newsdoesnotgetbakedinto
premiums in the same
manner. All options expiring
after a predictable event will
have premiums which reflect
the uncertainty surrounding
that event very soon after it
becomes public. The options
market,becauseitdependson
predicting the underlying
priceatafuturedate,doesnot
have the luxury of waiting
around.Theeventgetsbaked
intoImpliedVolatilityalmost
immediately.
Stock Trader: So that is
another reason to choose the
righttimeframeformytrade.
IfIwantedtobuyCallsona
stock in September and the
company was releasing its
earningsreportinNovember,
I would be taking on the
addedriskoftheeffectofthat
report if I chose the
Decemberexpiration.
OptionzTraderz:Exactly.If
you had no other reason to
keep the trade open for that
length of time, you would
likely find much more
attractive premiums on Calls
expiringbeforethereportwas
due.
StockTrader:Anythingelse
Ishouldwatchoutfor?
Optionz Traderz: There is
always the unpredictable, the
Black Swans, but you can’t
do anything about those
except cut your losses when
you are able to do so.
However anything that has
uncertainty associated with it
and also a predictable
timeframeisworthnoting.As
we
already
discussed,
earnings, product releases,
pending litigation resolution,
regulatory decisions, but also
upcoming changes in a
company’s leadership and
even political elections and
pending legislation can
sometimeshaveaneffect.
StockTrader:That’salotto
thinkabout.
Optionz Traderz: In my
opinion,itisnotnecessaryto
study all of these events in
depth;theyarealljustthings
to consider so you can avoid
as many unwanted surprises
as possible. You wouldn’t
wanttobuyCalls,thenwake
up the day after an election
and be startled to find that
volatility had evaporated and
taken a lot of their value
along with it. But if you
understood that risk going
into the trade, it wouldn’t
causeyoutolosefaithinyour
system.
Stock Trader: Having faith
in my system and feeling
comfortable trading it are
very important. I’m not yet
surewhetherIwouldbemore
comfortable selling options
and generating income, or
spending my money buying
options like lottery tickets,
lookingforthebigwinners.
Optionz Traderz: Many
traders do both. And you
don’thavetolimityourselfto
justbuyingorsellingCallsor
Puts. There are many
different strategies you can
use that entail combinations
of options, like the Straddles
andStrangleswetalkedabout
a while back. There are also
many,manydifferenttypesof
Spreads – everything from
Vertical, Calendar, and Ratio
Spreads to Butterflies and
Condors. But we’ll have to
wait for another time to
discuss those. The pizza I
orderedjustgothereandI’m
starving.
Stock Trader: As always,
thanks for the advice. Enjoy
yourpizza.
StockTraderhadalot
to think about. Options were
such simple things, and yet
trading them was turning out
to be utterly complex, not
unlike stock trading. Still, he
remained confident that
having found a method of
trend trading that allowed
him
to
conquer
the
complexities of the stock
market, with help from
Optionz, he would be able to
conquertheoptionsmarket.
He now had Theta,
Vega, Delta, and all of the
other Greeks under his belt,
and that made him feel a lot
more confident. He also had
Covered Calls, Naked Calls,
Puts, and out-of-the-money
‘lottery ticket’ options in his
tool box, and knew how to
use each one. But there were
so many variables in the
market, and the tools he had
were mostly designed to be
used during very specific
market conditions. How
would he deal with rangebound markets, volatile
markets,andthelike?
MaybeOptionzwould
have answers next time they
talked. Maybe those other
strategies that Optionz talked
about,
the
Spreads,
Butterflies, and Condors,
would be the additional tools
he needed to trade in every
market.
It was all just too
much to digest for one day.
The same could not be said
for his stomach. The energy
drink he had at the coffee
shop earlier in the day was
not going to be enough to
sustain him now. He needed
somerealfood,likethepizza
Optionz
was
probably
enjoying. In fact, a pizza
soundedlikeagoodidea.He
quickly tore some leftover
pizza coupons out from
underneath a magnet on his
refrigeratorandpickedupthe
phonetoorderonefordinner.
While he was waiting
for his pizza to be delivered,
Stock Trader kept thinking
aboutoptions.Itwasdifficult
for him to concentrate, being
so hungry. He felt his
stomach grumbling, but he
knewhewouldsurvive.After
all, the pizza shop had
promised him that his order
would be delivered in 30
minutes.Theminutesseemed
totickbyeversoslowly.He
lookedupattheclockonhis
microwave oven. “Just 10
minutestogo,”hethought.
Maybe it was the
hunger, maybe it was the
barrage of analogies that
Optionz had thrown at him,
but Stock Trader was now
thinking of his stomach in
terms of option trading. He
knew he would not starve to
deathinthenexttenminutes.
He knew he would soon be
full, probably overly-full,
afterfinishingoffmorepizza
slices than he should have
eaten. “If my stomach was a
stock, it would have found
support at the 200-day
average and would soon be
headedforall-timehighs,”he
thought. “This would be the
time to buy an out-of-themoney Call.” As Stock
Trader was getting deeper
and deeper into thought, the
doorbell rang and brought
himbacktoreality.
“Thepizza!”
“Your total comes to
$26.50.”
“O.K., keep the
change.Thanks.Haveagood
night.”
“$30forapizza?Now
I literally am out-of-themoney,” he chuckled out
loud.
Chapter10
TRENDS
DETERMINE
WHOWINS:
STRANGLES
AND
STRADDLES
StockTraderwokeup
and glanced at quotes on his
phonebeforeevengettingout
ofbed.
TheDowwasupover
400points.
“Wow,whatamove!”
hethought.
Onceagainhewason
the sidelines, due to the wild
swings in the market and all
the doubt surrounding the
debtproblemsinEurope.
He figured that he
couldnotpredictwhatwould
happenorevenfollowatrend
with all the uncertainty. He
figured that the European
Union would do whatever it
took to avoid a systemic
financial
meltdown.
However, anything could
happen when that many
countries got together to
agreeonwhattodo.
The stock market was
being held hostage by
governmentdecisions,andhe
justdidnotwanttobeonthe
wrong side. It was apparent,
from the magnitude of the
move, that the markets got
what they wanted overnight
inEurope.
“I wish there was a
way for me to bet on a huge
movebothways,”hethought.
Thenhethoughtabout
the option strategy Optionz
Traderzhadusedinthepast.
“Whatwasthatoption
playwetalkedabout?Wasit
an option Stripper? No.
Striker, Strangle, Straddle;
yes, that was it! How did I
forget about that play? Of
course, the option strategies
of Strangles and Straddles.
Crap!”
“Surely he didn’t use
thatagainandwin,whileIsat
herelookingdumbandscared
incash.”
“I wonder if Optionz
is online this early in the
morning?”hesaidoutloud.
He checked the
Winning Traders group on
Facebook and found that
Optionz was indeed online,
but he was engaged in a
conversation with another
trader. Stock Trader sat
quietly, watching a very
interesting discussion going
on in the group. He felt he
would be showing poor
mannersifheinterrupted.
Trend Trader: So you won
even though you had no idea
whichwayitwouldgo?How
intheworldisthatpossible?
OptionzTraderz: I bet both
ways.
TrendTrader: So were you
bullishorbearish?
Optionz Traderz: I was
‘trendish.’
TrendTrader:What?!
OptionzTraderz: I believed
thenewsoutofEuropewould
cause a sharper than
anticipated move one way or
the other. So I bought both
Call and Put options, one
strike out, on the Dow Jones
Industrial Average ETF
(DIA).
Trend Trader: So didn’t
theyevenout?
Optionz Traders: The thing
about option contracts is that
they capture the upside and
limit the downside. After the
400-point rally, my Call
options were worth far more
thanmyPutoptionshadlost.
Trend Trader: Your Put
optionsstillhadvalue?
Optionz Traderz: Yes,even
though they are now far outof-the-money, they are not
worthless; with the high
volatility in the market they
still have some Theta value.
InthepastIhaveevenleftthe
losing option side open and
then been able to exit that
side when the market had
anotherstrongreversalmove,
afewdayslater.
TrendTrader:Thatiscrazy,
I have never heard of that
kind of trading. I focus on
trendidentificationandgoing
in the direction of the
predominant
trend
in
whatever markets I am
trading.
Optionz Traderz: I profit
fromoptions.Itradedifferent
strategies based on the
currentmarketbehavior.
Trend Trader: So you have
option strategies that allow
you to bet on a trend, not a
direction, just that there will
beatrend?
Optionz Traderz: Yes, they
are called Strangles and
Straddles.
Trend Trader: That sounds
complicated.
Optionz Traderz: They are
not really that complicated.
Strangles are formed when
youbuybothaPutandaCall
out-of-the-moneyonthesame
equity. A Straddle is created
whenyoubuybothaCalland
aPutat-the-money.Strangles
require less capital outlay, so
thereislessriskoflossifyou
are wrong. But you need a
strong move to bring one of
them deep enough in-themoney before expiration to
make enough profit to offset
the cost. A Strangle can
expire 100% worthless when
neithersidemakesitinto-themoney. It can also have a
huge percent return on the
capital at risk by one side
goingdeepinto-the-money.
TheStraddlecapturesthefull
move of the equity in-themoney. One of the options
will be in-the-money almost
instantly and will always be
worththeamountofthemove
in intrinsic value. Also, the
oddsare,afterastrongmove
the losing side will still be
worth something. However,
althoughtheStraddlerequires
more capital, it requires a
smaller move than an option
Strangle to make enough on
the winner to pay for the
loser.
Trend Trader: So during
this European crisis, I could
have structured a trade based
on what I thought was the
velocity of the move either
way?
OptionzTraderz:Youcould
have also picked which
trading vehicle would be the
one to move – a specific
bank, sector, index, maybe
even gold – the one you
thought would have been
mostimpacted.
Trend Trader: If I was
betting on a 200-point DJIA
swing,Icouldhaveboughta
Strangle using the ETF DIA,
out-of-the-money $2 both
ways (equivalent to 200
points)andmadeaverygood
percentagereturn.
Optionz Traderz: Not only
can you capture that strong
move without prediction, but
you would own the complete
upside from that point, with
noadditionalinvestmentuntil
theoptionsexpired.
Trend Trader: How does
this work? It seems like the
losing side would even out
theprofitonthetrade.
Optionz Traderz: Straddles
are built to capture one side
ofanestimatedmoveforaset
period of time, for a
premium. They are contracts,
not
investments,
part
ownerships,orequities.They
have limited downside but
unlimitedupside.
Trend Trader: Like built-in
stoplosses?
Optionz Traderz: Sort of.
Youpayabulltosellyouthe
downside and a bear to sell
you the upside. Your profits
come when it becomes
evident that one of them did
not charge you enough to
participate in the trend when
it happens. They both took
the risk of a bigger trend
occurringthanwhattheyhad
anticipated.
Trend Trader: So profits in
this strategy come from
biggerthanexpectedtrends?
Optionz Traderz: Yes, like
stock trading, sometimes the
trend happens and then
reverses so many times that
you have to take your profits
while you have them. The
value of the option reflects
the probabilities of the value
oftheoptionatexpiration,so
they may not go up as much
as you expect because the
option may be pricing in the
chance that the trend may
reverse before the option is
exercised.
Trend Trader: So what
happens if I bet on a 200point move, and after the
announcementthereisonlya
100-pointmove?
Optionz Traderz: You will
lose in the short term. After
thecatalystpasses,bothsides
of the option strategy lose
time value, to reflect the
lower
expectations
volatility.
of
Trend Trader: What if it
drops 500 points while I am
intheoptionStrangle?
Optionz Traderz: Then you
are in-the-money. I have
actually been in one before
when that happened and
returned 5% on my whole
accountinonedaywithonly
5% of total equity at risk.
That was a 100% return on
myoptionsin24hours.
Trend Trader: Wow, those
are amazing risk-adjusted
returns. In what other events
would
you
use
the
Strangles/Straddles, besides
nationalcrisisnews?
OptionzTraderz:Onamore
normal basis, when entire
nations are not discussing
their solvency, they can be
used for company earnings
reports. Unexpected earnings
can spike a stock far more
than is anticipated when
after-hours traders scramble
togetinorout.Emotionscan
driveastockfartherthanwas
anticipated when earnings
cause greed or fear to run
wild.
Trend Trader: That is the
truth. There have been many
moves
that
are
just
unbelievable when a hot
stock disappoints or when
everyone piles in after the
company knocks the cover
off the ball in an earnings
report.
OptionzTraderz: You want
anepiceventinthemarketor
astock.Ifyoufindoutthata
company has any upcoming
news event that may
determineitsentirefutureone
wayortheother,thatmaybe
the time to put on a Strangle
orStraddle,tocapitalizeona
trend that could be far
strongerthanisanticipated.
TrendTrader: What are the
risks?
Optionz Traderz: There is
always the risk that the
market does not make the
sharp move that you
anticipated and the value of
volatility built into the
options collapses, or the
market only moves far
enoughforyoutobreakeven.
Also, like I said, if you hold
on and wait for a move that
never comes, both sides of
your
Strangle
expire
worthless. Worse yet, you
could have a Straddle that
expires right at-the-money
where you started – a total
loss.
TrendTrader:Howcanyou
helpmanagetheserisks?
OptionzTraderz:Whenyou
are wrong, the best thing to
doisjustgetoutearlyandgo
look for a new play. Never
hold until expiration unless
you are just so deep out-ofthe-money that the liquidity
has dried up in that contract
andyouwouldlosetoomuch
inthebid/askspreadtojustify
selling it. Also, sometimes a
bigger move than you expect
may be priced-in and the
optionsarejusttooexpensive
to be able to profit. This has
happened to me many times.
When I buy Straddles, I am
looking for the underestimation of the seriousness
of an event to move the
market.
Stock Trader did not
want to appear as if he was
rude, but his curiosity was
increasing. The Dow had
soared more than 400 points
inoneday,amovethatcould
have given him thousands of
dollars in profits. But his
trend trading system did not
work efficiently in volatile
whipsawing markets, so he
was on the sidelines, waiting
forthemarkettosettledown.
Meanwhile, Optionz seemed
almost as if he welcomed the
recent volatility. It was time
togetsomeanswers.
Stock Trader: Sorry to
interrupt. You are a good
teacher. Did you pull off
anotherLongStranglemoney
heist?
Optionz Traderz: Yes, I
started building a position
when all the drama began in
Europe. I bought when the
optionsweremoreaffordable,
whenvolatilitywaslower.As
volatility grew and the down
trend deepened, my options
alsogrewinvalue,withboth
increasing Vega and my Put
side going in-the-money. I
closedoutmyfirstplay,then
openedupanewone,andlost
with the market being range
bound. My latest short term
play on the EU bailout
announcement worked well,
withthe400-pointpopinone
day.
Stock Trader: So what is
yourStrangle/Straddlesystem
winrate?
Optionz Traderz:
about50%.
Only
Stock Trader: Big wins,
littlelosses?
Optionz Traderz: Exactly.
My wins pay for my losses
andleavemeaprofit.
TrendTrader: So to win in
anoptionStrangleorStraddle
I have to be right about the
timing of the trend and the
velocity?
Optionz Traderz: Yes, they
areonlyfortimesofmassive
uncertainty, with outcomes
that have the potential to
move violently one way or
the other. You have to
overcome the priced-in
volatility of the options to
win.WhenyoubuyStraddles
or Strangles, you are betting
that volatility will change.
Either Implied Volatility will
increase significantly and
stockswillsellofforImplied
Volatility
will
fall
significantly and stocks will
surge.
Trend Trader: What about
exits?
Optionz Traderz: Just like
in trend trading, you might
want to exit on a stop when
the trend reverses, or you
mighthaveatimeexit,where
you exit after the event
catalyst has passed and you
presume that the move has
alreadyhappened.
Stock Trader: What is true
in stocks is also true in
options. The only difference
is just a few more moving
parts.
TrendTrader:Ineedtolook
at some option chains and
reallygetthefeelforhowthis
works. I think I have the
basicsnow.
Optionz Traderz: Good for
you.GladIcouldhelp.
Stock Trader: So how do
you decide when to use a
Straddle and when to use a
Strangle?
OptionzTraderz: Often,the
outcome of both strategies is
similar, especially on more
volatile stocks. If you
consider an at-the-money
Straddle on a stock, Delta on
bothoftheoptionswilllikely
be close to 0.5. That means
that lowering the strike price
of the Put by $1 should save
you about 50 cents in
premiums, while increasing
the strike of the Call by $1
would do the same. All
togetheryouwouldsave$1in
premiums, but be entitled to
$1 less of any trend that
developed.Inacaselikethat,
I would choose the Strangle
over the Straddle because I
would have the same
potential profit with much
lesscapitalatrisk.
Stock Trader: That is
interesting. The Strangle
would cause me to miss out
onthefirst$1ofthemovein
the stock price, but would
save me $1 in premiums
comparedtotheStraddle.
Optionz Traderz: Exactly,
sowhyputyourselfatriskof
losingtheadditionalpremium
if no move ever occurred?
You would lose a lot more
money on the Straddle, but
have nearly the same profit
potentialasaStrangle.
Stock Trader: So if I went
out$2inpriceonthestrikeof
bothoptions,wouldn’tIsave
$2inpremiumsandthenmiss
the first $2 of any change in
thestockprice?
Optionz Traderz: Not
necessarily.Thatmaybetrue
on very volatile stocks, but
those with lower volatility
have Deltas that drop off
considerably with strike
prices that are out-of-themoney. So it is possible that
moving out both options by
$2mightonlysaveyou$1.50
orsoinpremiums.Onstocks
with very low Implied
Volatility, you might save
evenless.Butyouarecorrect
when you are talking about
Strangles on highly volatile
stock.
Just as an example, Trend
Trader had asked me about a
Strangle on the DIA ETF.
With the shares currently
trading around $116, a
Strangleconsistingofa$114
Put and $118 Call with
November expiration would
haveacombinedpremiumof
$4.31andwouldpickupany
movement of the share price
in
excess
of
$2.00.
Meanwhile,
a
Straddle
consisting of a Call and Put,
bothatthe$116strike,would
cost $6.17 and pick up every
penny of movement in either
direction. So while the
Straddle would have an
additional
$2.00
gain
comparedtotheStrangle,the
Straddle costs $1.86 more to
open; you really aren’t
getting much added benefit
from a Straddle versus a
Strangle, but you are taking
onalotofadditionalrisk.
StockTrader: So a Strangle
would be better on volatile
stocks. What about less
volatileones?
Optionz Traderz: That’s a
choice you need to make
basedonwhatyourindicators
are telling you about the
market and how confident
you
are
about
that
information. Straddles are
very expensive, so it takes a
big move to offset their cost.
Strangles are less expensive,
but it actually takes a bigger
move in the underlying price
to generate a profit than
would be necessary with a
Straddle.
Stock Trader: That seems
strange.Iwouldhavethought
a Strangle would perform
better because of the lower
initialoutlay.
Optionz Traderz: If you
considerthatthepremiumon
an at-the-money option is
equal to approximately 40%
of one standard deviation of
the underlying stock price,
based on the amount of time
to expiration, then a Straddle
will generally cost you about
80% of one standard
deviation. So the stock price
wouldneedtomove80%ofa
standard deviation just to get
to the break even point. That
might seem like a lot, but
stocks generally only stay
within such a tight range
aroundhalfofthetime.
If you compare that to a
Strangle,withstrikesthatare
out-of-the-moneybyhalfofa
standard deviation, they will
usually cost about half as
much as those required for
the Straddle. Because they
cost half as much, their
combined premiums are
about 40% of one standard
deviation. So the underlying
priceneedstomove50%ofa
standard deviation just to get
to the strike price, then
another 40% of a standard
deviation to get to the break
even point, which would
likely be near 90% of one
standard deviation – slightly
more than is required for a
Straddle.
Stock Trader: So if I was
confident that my technical
analysis was pointing to a
strongtrend,aStraddlewould
be a better choice because it
would have a better payout.
But if I was less sure of a
trend, I could cut my risk in
halfifIchoseaStranglewith
strikes about half a standard
deviationout-of-the-money.
Optionz Traderz: That is
true. The profit from the
Strangle would be slightly
lower, but with about half as
much capital at risk. As
always, you need to make
suretheoptionshaveenough
liquidityatthestrikesyouare
choosing.Stranglesaremuch
more vulnerable to liquidity
issues than Straddles because
out-of-the-money
options
almost always have larger
bid/ask spreads, and you are
exposed to that risk on both
legsofthetrade.
Stock Trader: Good point.
Anythingelsetoconsider?
Optionz Traderz: Well,you
don’tneedtoconfineyourself
to buying Straddles or
Strangles; you can also sell
them.
Stock Trader: That seems
riskier than the Naked Puts
weweretalkingabout.
Optionz Traderz: Yes, they
do have risks, but like every
option strategy, the key is
managingthatrisk.
StockTrader:Sohowwould
I manage the risk on a short
StraddleorStrangle?
Optionz Traderz: The first
thing to do is to make sure
you are selling them at the
right time, to give yourself
better odds. When the
markets are losing value and
volatility is rising quickly,
Straddles and Strangles can
beveryrisky.Notonlywould
you be risking a big loss on
the Put side if the downtrend
worsened,
but
Implied
Volatilitywouldprobablyrise
too, and that would likely
increase your loss. Short
Straddles and Strangles both
have a slightly bullish bias;
many times they perform
better when prices are rising,
due to Vega causing them to
losesomeoftheirtimevalue.
Stock Trader: So when
prices are starting to recover,
but volatility is still high,
would that be a good time?
I’dstillbegettingsomegood
premiums, but if the uptrend
continued and volatility
declined, I’d be able to cut
anylossesontheCallsideof
the trade and take profits on
the Put side, because
volatility would be working
inmyfavoronboth.
Optionz Traderz: Exactly.
Bearmarkets,withincreasing
volatility, are usually more
dangerousforShortStraddles
and Strangles than bull
markets. So once you have
picked a good time to open
thetrade,thenextthingtodo
is to choose the right strike
price. You might be tempted
tosellaStrangleinsteadofa
Straddle because of a fear of
having one of the options
immediately being in-themoney.
Stock Trader: Yes, that is
probablywhatIwoulddo.
Optionz Traderz: It is
definitely unnerving to have
short option positions that
have intrinsic value, even for
me, after all these years of
trading.ButIfinditisbestto
avoid letting that fear
influence my trades. The
strike prices should be based
on the probability of the
entire trade being profitable
and whether the premium
receivedisworththerisk.
StockTrader:That’sagood
point. I would be tempted to
sell a Strangle with strike
prices so far out-of-themoney that there was no
chance of either strike price
being hit. But the premiums
that far out are usually tiny.
ThehigherpremiumsIwould
getonaStraddlemightmake
itabettertrade.
Optionz Traderz: Yes, like
wetalkedaboutearlier,some
Straddles and Strangles
perform almost identically,
especially on very volatile
stocks. If the market was
volatileenoughandtherewas
sufficient time to expiration,
you might be able to collect
$1morebysellingaStraddle
than you would receive for a
Strangle with the strikes
movedoutby$1.Inthatcase,
when you planned on selling
optionsinsteadofbuying,the
Straddle could make more
sense. If we use the DIA
example again, you could
collect $1.86 more on a
Straddlethana$2out-of-themoneyStrangle.
Stock Trader: That makes
perfect sense. I would be
obligated for an additional
$2.00 in intrinsic value when
the stock price moved, but I
would receive an extra $1.86
inpremiums.SoIwouldonly
betakingonanadditional14
centsofriskbutIwouldhave
apotentialadditionalprofitof
$1.86 if the ETF’s price
didn’tmoveatall.
Optionz Traderz: You
nailed it! Why leave that
extra money on the table
when it isn’t causing you to
takeonmuchadditionalrisk?
It’sallaboutriskandreward.
If it makes sense to buy a
StrangleinsteadofaStraddle
because the small amount of
additional reward does not
justify the risk of a trend not
occurring, then selling a
StraddleinsteadofaStrangle
could also make sense. All
you need to do is weigh the
risk against the reward and
decide whether the potential
increased reward justifies the
additionalrisk.
Stock Trader: That is
fascinating. A Straddle can
behave almost the same as a
Stranglewhentheunderlying
pricemoves,buttheprofitor
loss is much different when
thepriceremainsflat.SoifI
combined the two, say by
buyingaStrangleandselling
a Straddle, wouldn’t that
guaranteethatIwouldmakea
profitnomatterwhat?
OptionzTraderz:Holdona
minute; you’re learning too
fast for me again There is
actually a name for the
strategy you described: an
Iron Butterfly. But like all
option strategies, it doesn’t
winunderallconditions.The
Strangle that you are buying
will always cost somewhat
lessthantheStraddleyouare
selling, a net credit trade.
WheneveryoutradeStraddles
orStranglesandreceiveanet
credit,youarebettingagainst
a trend. The opposite is also
true; when you pay a net
debit, you are betting on a
trend. You receive a net
creditwhenyouopenanIron
Butterfly, but if either of the
optionsyousoldexpiredwith
intrinsic value greater than
thatcredit,youwouldhavea
loss. I’d be happy to explain
Butterflies to you in detail,
butitwouldprobablybeless
confusing if we got through
StraddlesandStranglesfirst.
Stock Trader: O.K., you’re
theteacher
Optionz Traderz: When
choosing strike prices for a
Strangle, some traders prefer
buying a Put at a strike price
near a recent support level
and a Call at resistance. The
premiums are much lower
with these options being so
farout-of-the-money,sothere
is much less capital at risk.
The downside is that both
options will usually expire
worthless. But when they do
pay off, the profits can be
huge.
StockTrader:Andthesame
would go for selling a
Strangle;aPutatsupportand
a Call at resistance would
probably
both
expire
worthlessmostofthetime.
Optionz Traderz: Yes,
whetheryousellaStraddleor
a Strangle, you are betting
thatastockorthemarketasa
whole is range bound. How
wide that range is will be
determined by the strike
prices of your options; the
further out-of-the-money you
go,thewidertherange.There
may actually be times, like
when the Dow was
whipsawing
violently
recently,
that
Implied
Volatilityincreasestoalevel
thatmakesitpossibletosella
Straddle and still keep your
range of profitability in
between
support
and
resistance. Other times you
may have no choice but to
useaStrangle,ifyourgoalis
to include support and
resistance levels within that
range.
Stock Trader: I think I
understand now. Buying
Straddles or Strangles is a
‘trendish’strategyandselling
them is a range bound
strategy. The strike prices
determine how ‘trendish’ or
range bound I am predicting
futurepricestobe.
Optionz Traderz: Correct.
So now that you understand
when to use each strategy,
you need to consider the
timeframe of the trade.
Option combinations react
muchmoreslowlytochanges
in the underlying price than
single options. For example,
when you open a Straddle,
DeltaontheCallisnormally
closeto0.5andonthePutit
is about -0.5; the position is
initially nearly Delta neutral.
So even if the underlying
pricedidmove,thecombined
position wouldn’t change in
value much due to Delta,
unless the magnitude of the
move was great enough. In
the meantime, Theta would
be eating up some of the
value.
StockTrader: I guess we’re
back to matching the
expirationdateoftheoptions
withtheexpectedtimeframe
that any prediction about a
stock’spricewouldbevalid.
Optionz Traderz: That is
onewaytolookatit.Butyou
don’tneedtolimityourselfto
that timeframe. As with all
option strategies, Straddles
and Strangles behave much
differentlydependingontheir
expiration date. A Straddle
with a near month expiration
will be much more sensitive
totimedecaythanoneafew
monthsout,butitwillcapture
movesintheunderlyingprice
muchmoreclosely.Also,the
near term Straddle would be
much less sensitive to
changes in volatility. You
need to weigh the risks
associatedwitheach.
Stock Trader: So if a stock
wasrangeboundandIsolda
Straddle one month out, I
would benefit much more
fromtimedecaythanifIused
options two or three months
out,butIwouldbetakingon
more risk if the stock broke
out.
Optionz Traderz: That is
true, so you may want to
adjust your position size to
compensatefortheadditional
risk.
StockTrader:Goodpoint!If
I am making more profits
from faster time decay by
selling options with shorter
terms, I don’t need to sell as
manycontracts.
Optionz Traderz: You can
alsousethefastertimedecay
another way. Let’s say you
noticed that one of your
favorite stocks normally
remained range bound for
aboutthreemonthsaftereach
earnings
announcement.
Perhaps
after
the
announcementinOctoberyou
were looking to sell ten
Strangles with January
expirations. Let’s assume
each Strangle would get you
$2 per share in premiums.
Also assume that they would
lose about 10% of their time
valueinthefirstmonth,ifthe
underlying
price
and
volatility remained stable.
How much of a gain would
you have at the end of the
firstmonth?Asalways,there
are 100 shares in one option
contract.
Stock Trader: LOL,another
mathproblem.O.K.$2x10x
100 = $2000. 10% of $2000
is$200.SoIwouldonlyhave
a gain of $200 after the first
month?
OptionzTraderz: Youare
getting better at math. Now
assume that the premium on
the November options was
approximatelyhalfthatofthe
January options with the
samestrikeprices.Howmany
November Strangles would
you need to sell in order to
earn$200byexpirationday?
Stock Trader: I think I can
do this. Each Strangle would
have a premium of about $1;
so $100 per contract. That
means I could sell two
Strangles with the November
expiration and potentially
have the same $200 profit
after the first 30 days as if I
had sold ten Strangles with
theJanuaryexpiration.
Optionz Traderz: Exactly.
The good news is that if the
stock remained range bound
and the November options
expired worthless, you could
probably still sell ten
Strangles at that point with
theJanuaryexpirationandget
the remaining $1,800 in
premiumsyouwereoriginally
seeking.
Stock Trader: That is really
interesting. The profit would
bethesame,butIwouldhave
substantially decreased my
riskduringthefirst30days.
Optionz Traderz: That’s
what trading is all about,
seeking out the best profits
with the least amount of risk
possible.
StockTrader:Sohowwould
yousuggestmanagingaShort
Straddle or Strangle once the
tradeisopen?
Optionz Traderz: Just treat
each leg of the trade as if it
were a single Naked Put and
Naked Call. Cut your losses
on the losing side when you
are able to do so, and take
your profits on the winning
side when your technical
indicators tell you that the
timeisright.Justaswithany
Naked option, you also have
the choice of rolling the
losing leg to a farther-out
expiration date and a smaller
numberofcontractsoramore
favorablestrikeprice.
Stock Trader: I think I’m
startingtoseeathemehere.It
doesn’tmatterwhatstrategyI
am using; the basic rules are
the same. All I need to do to
succeed is choose the correct
strategy for the current
market conditions, increase
my probability of a profit by
choosing the appropriate
strike prices, limit my losses
by selecting the best
expirations, manage the
trades with stop losses or by
rolling, and take my profits
off the table the same way I
wouldifIwastradingstocks.
Optionz Traderz: That is
thereistoit.Whenyoutrade
options,thecurrentcondition
of the market is always a
concern, but never a major
problem.
Stock Trader: Professional
optiontradersreallyhavethe
goodlife.
OptionzTraderz:Itcanbea
good life, but it takes some
work. My Long Straddle on
DIA worked out very well
thisweek,butitcouldjustas
easily resulted in a big loss.
Infact,itwassuchabigwin
that my girlfriend and I are
goingoutinmyCadillaclater
todaytocelebrate.
Stock Trader: So you
celebrate all of your winning
trades?
OptionzTraderz:Oh,byno
means.Ihavewinningtrades
all the time. But some trades
take a lot of work. I started
working on my DIA options
trade weeks ago and endured
some initial losses. There
weretimesthatitlookedasif
it would be a total loss. But
my system told me to stick
with it and I did, and the
resultwasabigwin.I’mnot
goingouttocelebratethewin
itself; I’m going out to
celebrate the success of the
system.
Stock Trader: I know how
you feel. I like it when my
stocktradingsystemhasabig
win. It makes all of the
previouslossestolerable.
Optionz Traderz: Yes,
losses are part of the
business, and they are
frequent.Whenthehardwork
finally pays off and the
system proves that it works,
whynotcelebrate?
StockTrader:Iagree.Enjoy
your
night
out
and
congratulations on a nice
trade…again.
OptionzTraderz:Thanks.
Chapter11
THETWINS:
EVERY
POSITIONHAS
ASYNTHETIC
RELATIVE
Stock Trader was
simply having fun learning
from Optionz online. He felt
attimeslikehewasstudying
a foreign language. Stock
options contained a lot of
moving parts and could be
combined for a dizzying
amountofdifferentstrategies.
Stock
Trader
pondered some of the things
hehadlearned.
“Option sellers could
make money from the
deterioration of an asset they
soldshort.”
“Traders could bet on
atrendineitherdirection.”
“Traders could make
moneybettingtherewouldbe
notrend.”
Catching the full
upside of a move with an
automatic limited downside
was something he really
liked.
“Withoptions,traders
could be in control of huge
blocks of stock with little
moneyinvested.”
“Stock trader could
usestockoptionsashedgesor
insurancepolicies.”
Stock Trader just
couldn’t get enough option
talk. He went right back into
thefray.
He signed on and
went to the group online that
was getting to be a regular
hangoutforhim.
It appeared a new
student was being schooled.
“Thisshouldbeinterestingto
watch,”hethought.
Income Investor: I heard
youwerethegroup’sresident
guru on stock options. I sell
Call options for income on
my investment portfolio. The
strategyisnotworkingoutas
wellasIhadhoped.
OptionzTraderz:Whydon’t
you just sell Naked Puts for
incomeinstead?
Income Investor: I would
neversellaNakedPut;thatis
way too much risk. It makes
my stomach queasy just
thinkingaboutit.
Optionz Traderz: Well, I
have some news for you.
They are the same thing,
technically.
Income Investor: What?
That is crazy they are
completelydifferent,Covered
Calls are for income and
NakedPutsareawildgamble
withhugerisks.
OptionzTraderz:Howisthe
risk in a Naked Put different
fromaCoveredCall?
Income Investor: A stock
could crash and you would
stillhaveitputonyouataset
price much higher than what
it was worth currently at the
marketprice.
Optionz Traderz: But you
receiveincomefortheNaked
Put.
Income Investor: That is a
small fee for taking on the
risk of a stock crashing and
possiblycausingmetobeleft
holding the bag. This could
cause me to have to buy a
stockforwayoverthemarket
value.
Optionz Traderz: How is
that different from Covered
Calls?
Income Investor: I already
ownthestockonwhichIam
writingtheCall.Idonothave
the risk of having it put on
me.
Optionz Traderz: That is
becauseyoualreadyputiton
yourself.
Income Investor: It is an
investment.
OptionzTraderz: Then why
would you not sell Naked
Puts on stocks you would
wanttoown,andiftheywere
put on you, it would be
initiatinganinvestment?
Income Investor: I do not
like the idea of offering to
buyastockatasetprice.
Optionz Traderz: With a
CoveredCallyouareoffering
toholdastockforasetprice
and risk the entire downside.
Whatisthedifference?
Income Investor: I already
ownthestock.
Optionz Traderz: Correct,
you already own the
downside.
Income Investor: I own the
downside? I never really
thoughtofthat.
Optionz Traderz: In a
Covered Call you get paid a
small fee to take on the
downward risk of the stock
that you own. In a Short Put
youcollectasmallfeetotake
on the downward risk of a
stock you must buy at the
strike in the future if
exercised.Itisthesametrade,
samerisk.
Income Investor: O.K., that
makes my head spin. I can’t
believe that a Covered Call
option has the same risk
profileasaNakedPut.
Optionz Traderz: Say you
own Apple at $385 and you
sell a Covered Call option at
$390 and collect $15. You
make money from $370 and
up in price. If you sell a
Naked Put at $390 for $15
you make money from $370
and up in price. Your risk is
to the downside in both
strategies. The difference is
thatyoualreadyputAppleon
yourself before you entered
thetradeontheCoveredCall,
andintheNakedPutyouwill
haveitputonyoulater.
IncomeInvestor:Iamtaking
on the same risk in both of
thesetrades?
Optionz Traderz: Exactly
the same risk; the only
difference is whether you or
thebrokeragefirmisexposed
to the downside. I have
discussed this in the group a
few times. It is one of the
greatestmisunderstandingsin
the option world. The risk
embedded in the Covered
Call, the infamous ‘stop
gain,’isthesameasaNaked
Put,tothetrader.Ifyousella
Naked Put and some
unforeseen event results in a
loss that is greater than the
entire value of your
brokerage account before a
margin call can be executed,
itisthebrokerwhoisonthe
hook.
Income Investor: I really
thought I was an informed
investor, but that just blew
mymind.
Optionz
Traderz:
In
investing
and
trading
financial markets, all we are
doing is trading risk. Each
instrument has an upside and
a downside and generally an
equal chance of the trade
moving towards or against
our bet when we enter any
position.
The
market’s
currentbehaviordeterminesif
we win or lose, not our own
genius.
Income Investor: What else
do I not understand about
options? I am a stock
investor,notanoptiontrader.
Optionz Traderz: Options
havetwinsthathavethesame
riskprofile.
Income Investor: Really?
WhatisaLongCalloption’s
twin?
OptionzTraderz:AMarried
PutisthesameasaLongCall
option. In a Married Put you
getthefullupsideandprotect
the downside by paying a
small fee. In a Call option
you get the full upside while
the downside is protected by
limiting losses to the small
feefortheoption.
Income Investor: Then why
would anyone use a Married
Put
and
pay
two
commissions?
Optionz Traderz: Married
Putsareusedforashortterm
hedge on a long term
position, sometimes to avoid
thetaxconsequencesofshort
term capital gains. Other
times they may be used to
protect gains on a stock an
investoralreadyowns.
IncomeInvestor: So when I
sold Covered Calls on the
stocks in my portfolio I was
selling the upside of my
stocks for the small fee and
keepingthedownsideriskfor
myself? Is that what you are
saying?
Optionz Traderz: You were
essentially writing Puts, but
the stock had already been
put on you. Calling a stock
from you or putting a stock
onyouissimplyamannerof
time sequence; they are not
differentprinciplesentirely.
Income Investor: So that
explainswhyIlosesobadin
bear markets, I have already
putthestockonmyself.Istill
havethelossesasifsomeone
had put it on me. I do not
know why I didn’t realize
this.
Stock Trader: Sorry for
butting in, but I'm curious.
What other option parallels
exist? I can’t wrap my brain
around what other option
twinsareoutthere.
Optionz Traderz: Well, let
me think. How about
Synthetic Stock positions?
Buying a Long Call and
selling a Short Put, both atthe-money, will give you a
Synthetic Stock. It behaves
thesameasifyouownedthe
stock itself and requires no
capital. You get the upside if
it goes up due to your Long
Call, and lose on the
downside with the Short Put
ifitgoesdown.Butyouhave
little to no capital outlay
becausetheshortoptionpays
forthelongoption.
You can also create a
Synthetic
Short
Stock
position, a Long Put and
Short Call at-the-money, and
it will give you the same
returns and losses as if you
wereshortthestockitself.
StockTrader:Iseeyouplay
with options like they are a
boxofbuildingblocks.
OptionzTraderz: Only they
aremorecolorfulandfun.
Income Investor: O.K., I
believe you guys have gone
way over my head. Synthetic
Stocktrading?Iamout.
Stock Trader: So you are
saying that there is a free
trade. By combining a Short
Put with a Long Call, you
will have a Synthetic Stock
positionthatcostsnothing?
Optionz Traderz: There is
always risk, and don’t forget
commissions. Also liquidity
riskcanbecomeanissuewith
lightlytradedoptionchainsor
as your winner goes deep inthe-money.
Stock Trader: That may be
the coolest thing you have
talked about yet. It is like
going to a build-a-bear
workshop and getting a free
bear built just the way you
wantit.
OptionzTraderz: Just make
sure it is not flammable – it
couldburnyourhousedown.
Stock Trader: Well, I guess
it may be a freebee position
butaSyntheticStockhasthe
same potential of loss as a
regularstockwould.
Optionz Traderz: Yes,
always remember position
sizing and the risk of ruin if
you are tempted to play with
these building blocks. Trade
the same size as you would
with real stock and risk the
sameamountofcapitalbased
onyoursystem,probablylike
1%-2% of total equity per
trade. There are also margin
requirements that can be
significantly higher than
those required for stocks.
When you open a Synthetic
Stock position, a portion of
your account will be on
margin from the very start.
That means you will be
paying interest on that
amount. Depending on the
movement of the stock price,
thatrequirementcanincrease,
so it is a good idea to check
your margin balance when
youtradeoptions.
Stock Trader: You know
howtothrowabucketofcold
water on my head when the
adrenal glands get pumping
andmygreedstartsgrowing.
Optionz Traderz: Synthetic
Stock is good for creating
extra trades without tying up
any additional capital, but it
does tie up some of your
margin. And don’t ignore
liquidity. You need to watch
the bid and ask price closely
when a Synthetic Stock
position has options that are
deep in-the-money and far
out-of-the-money. Liquidity
can dry up quickly, and you
would be left with a position
thatyoucouldnotclose,even
ifyouwantedtodoso.Some
tradersuseasetlimit,suchas
$0.05 or $0.25, where they
will close the position when
the bid price reaches that
level. Once the bid price of
the out-of-the-money option
goes beyond that, you would
likely be stuck with the
position until expiration day.
Inapositionthatwentinyour
favor, you’d be vulnerable to
a gap down that reversed the
trend and wiped out your
gains. Worse yet, in a
position that went against
you,youwouldhavenoway
tocutyourlossesiftheshort
options went so deep in-themoney that they lost their
liquidity.
Stock Trader: I really like
this idea. I could trade 100
sharesofApplebutinsteadof
tyingup$28,500totrade100
shares I could sell an at-themoney Put contract for $15
andthenbuyanat-the-money
Call contract for $15. Then I
owntheupwardmovementin
Apple for the cost of
commission.
Optionz Traderz: And the
downward risk. The Delta
rules still apply. No matter
what the price of the stock,
DeltaontheCallminusDelta
on the Put will always equal
1.Ifthestockpricedropsand
DeltaontheCallgoesto0.75
then Delta on the Put will be
–0.25.
Stock Trader: I hadn’t
thoughtofthat.0.75–(–0.25)
=1
Optionz Traderz: So you
will see a full reflection of
value at any given moment.
Unlikemostoptionstrategies,
you don’t need to wait until
expiration to see the full
value because the Theta is
paid for. You sold Theta to
buyTheta,soSyntheticStock
positions do not experience
timedecay.
Stock Trader: Selling Theta
and using it to buy Theta,
clever. Now I have heard it
all.
Optionz Traderz: Sorry to
disappoint you, but you
haven’t heard it all yet.
Understandingsyntheticswill
open up a whole new set of
toolsforyou.
Stock Trader: So there are
moresynthetics?
Optionz Traderz: Yes, I
don’t usually use formulas,
butthereisonlyoneformula
thatyouneedtorememberto
understand synthetics. Do
you remember when I gave
Rookie Trader that option
trade that was a guaranteed
winnereverytime?
Rookie Trader: Hey! Are
youguysmakingfunofme?
Optionz Traderz: I’m not
making fun, but I am using
yourinexperiencetomakean
important point. You should
payattentionhere;youcould
learnsomethingimportant.
Stock Trader: So, if I
remembercorrectly,thetrade
you gave him was to sell a
Covered Call and then buy a
Putatthesamestrikeprice.
Optionz Traderz: Exactly.
Buyingastock,thensellinga
Call and buying a Put, yields
a trade that cannot win or
lose. And that will give you
the formula for all synthetic
positions. Here it is: STOCK
–CALL+PUT=0.
StockTrader:I’mnotsureI
understand how to use that
formulathough.
Optionz Traderz: O.K., it
takes a little bit of algebra.
Areyouupforsomemath?
StockTrader:LOL,herewe
go again with the math
problems.O.K.,goahead.
Optionz Traderz: Well, just
leave the equal sign where it
is. What happens if you
subtract a PUT from both
sides?
Stock Trader: Let’s see.
STOCK – CALL + PUT –
PUT=0–PUT
OptionzTraderz:Youreally
aren’t as bad at math as you
think. Now consider the left
side of the equation for a
minute;youhaveaLongPut
and a Short Put, so they
canceleachotherout.Andon
the right side you have
nothing, minus a Put, so
that’sjustaShortPut.
StockTrader: So I’d be left
with STOCK – CALL = –
PUT
Optionz Traderz: You got
it! Stock minus a Call equals
a Short Put; a Covered Call
equalsaShortPut.
StockTrader:Ineverwould
have thought of it that way.
That’samazing.
Optionz Traderz: It doesn’t
end there. If you take the
original equation and add a
Call to both sides you get:
STOCK + PUT = CALL. If
you do the math for every
possible combination, you
willendupwiththislist:
POSITION SYNTHETIC
POSITION
STOCK=CALL–
PUT(LongStock=ALong
Call and a Short Put) –
STOCK = – CALL +
PUT (Short Stock = A
ShortCallandaLongPut)
CALL=STOCK+
PUT(ALongCall=Long
StockandaLongPut)
– CALL = – STOCK –
PUT (A Short Call =
ShortStockandaShortPut)
PUT = CALL –
STOCK (A Long Put = A
LongCallandShortStock)
– PUT = – CALL +
STOCK (A Short Put = A
ShortCallandLongStock)
StockTrader:Nowthatyou
putitthatway,itseemsmuch
simpler.So,thereareonlysix
syntheticpositions?
Optionz Traderz: That’s it.
Thosearethebasicsix.
Rookie Trader: I’m glad
you’renotmakingfunofme.
I took your advice and went
to an options seminar at a
hotel last weekend. I really
learned a lot. So I found the
problem with the Covered
CallsIwastrading;allIneed
to do is buy Puts three
months out, and then sell
monthly Covered Calls three
timestooffsetthepremium.
Optionz Traderz: How
muchdidyoupaytogetinto
theseminar?
RookieTrader:Itwas$150,
butitwaswortheverypenny.
Now I finally do have the
HolyGrail.
Optionz Traderz: I hate to
break it to you, but it is not
the Holy Grail. If there was
one,withallofthetraderson
Earth, somebody would have
founditbynow.Icouldhave
saved you the $150. Were
you paying attention to the
formulas
for
synthetic
positions?
RookieTrader:Yes.
Optionz Traderz: What is
the synthetic position for a
CoveredCall?
RookieTrader:AShortPut.
Optionz Traderz: So by
sellinganearmonthCovered
Call, you were opening the
equivalent of a Short Put. If
youcombinethatwiththefar
month Long Put, you have
the equivalent of a Calendar
PutSpread.
Stock
Trader:
What?
There’s actually a name for
thetradehedescribed?
Optionz Traderz: Yes,
although the exact trade he
described doesn’t have a
namethatIknowof,whathe
would be doing is the
equivalent of a Calendar
Spread. When you buy an
option with one expiration
andsellthesameoptionwith
a different expiration, that’s
all there is to a Calendar
Spread.Therearetimeswhen
such trades work well, but
they definitely are no Holy
Grail.
RookieTrader:Rats!
Stock Trader: I think I’m
starting to see the value in
learningaboutsynthetics.
OptionzTraderz:Yes,many
of these seminars and
expensive black-box trading
systemsdonothingmorethan
take simple trades and make
themlookoverlycomplicated
by substituting the positions
with
their
synthetic
equivalents.
Stock Trader: I guess that’s
somethingtowatchoutforif
I see a trading system being
toutedashavingsome‘secret
formula’forsuccess.
OptionzTraderz:Definitely.
In the past, I actually made
the mistake of buying one of
those systems. It sounded so
sophisticated that it certainly
would be worthwhile. The
method involved searching
themarketforstockswiththe
lowest correlation; when one
stockgoesup,theothergoes
down. Once the stocks were
chosen,allthatwasnecessary
was to sell Covered Calls on
bothstocks.
Stock Trader: That does
seemlikeitwouldbeagood
system.Whatwentwrong?
Optionz Traderz: First,
there are no stocks that have
an exact 0% correlation, so
there were times when both
stocks lost value. More
importantly, though, when
one of them hit the strike
priceoftheCall,thepriceof
the other was still dropping.
Ifthepriceofthelosingstock
fell beyond that point, by
more than the amount of the
premiums I received, I lost.
The Short Call caused me to
giveupallofthegainsonthe
winning stock while I owned
the full downside of the
losingstock.
Stock Trader: So was this
one of those simple trades
thattheyhadjustmademore
complex in order to get
traders to purchase the
system?
Optionz Traderz: Exactly.
The two Covered Calls are
equivalent to Naked Puts.
And because of the low
correlation, one Put behaves
theoppositeoftheother,soit
is more like a Naked Call.
Whenyouputthemtogether,
it is nothing more than a
Naked Call and Put, a Short
Strangle. In fact, I probably
wouldhavelostlesscapitalif
I had just opened a Short
Strangleinstead.
StockTrader:That’sagood
point. These marketing guys
really know what they are
doing to make a profit for
themselves,
not
their
customers.
Optionz Traderz: You
nailed it. So whenever you
are considering opening a
trade,itishelpfultoconsider
thesyntheticequivalent.Like
wetalkedaboutwithCovered
Calls, before you open one,
askyourselfifaNakedPutat
that strike price would make
sense. If not, why open it? If
you are thinking of buying a
stock and then using a
Married Put for protection,
askyourselfifyouwouldstill
open the trade if you were
simplybuyingaLongCallat
thatstrikeprice.
Stock Trader: Now you’ve
given me something to think
about. When I own a stock
that has done well, I
sometimes buy a Put instead
ofusingastoplossifaPutis
inexpensive enough, at a
strike that will get me out of
thetradewithaprofit.ButifI
consider that buying a Put is
the same as selling the stock
and buying a Call, I’d
probablyneverbuyaCallata
strikethatdeepin-the-money.
Optionz
always,
Traderz:
As
understanding
options is all about
understandingrisk.Youdon’t
need to trade synthetics in
orderforthemtohelpyou.In
the trade you described, I
don’tthinkeitherofuswould
choose to sell the stock and
buy a deep in-the-money
Call;
the
additional
commissions involved would
eat up a lot more of the
profitsthanbuyingaPut.But
thinking about the equivalent
syntheticpositionmightmake
you reconsider the risks of
keepingthetradeopen.
Stock Trader: Any other
thoughts?
OptionzTraderz: Well, as I
was telling Rookie Trader,
just because a trade looks
good on paper doesn’t mean
it is. When you think about
synthetics, it may help you
decide if the trade you are
planning is correct for the
current market conditions.
Some complex trades are
difficult to study; thinking of
them in simpler terms may
makeiteasier.
Stock Trader: That is true.
Rookie’s trade sounded O.K.
until you let the air out of it
by saying it was just a
CalendarSpreadindisguise.
Optionz Traderz: The good
news is that there are
conditions when his trade
would be an appropriate
choice. Even though his
position was nothing more
than a synthetic version of a
Calendar Spread, it would
workwellonastockthatwas
going
through
some
consolidationinitsprice.
Stock
Trader:
That’s
interesting. I never would
have thought to trade two
options
with
different
expirationdates.
OptionzTraderz:Andthat’s
just one of many ‘Spread’
strategies.Thereareplentyof
themtochoosefrom.
Stock Trader: So Rookie’s
comments have opened up a
whole new toolbox? Now I
reallyhavehearditall.
Optionz Traderz: Oh, we
are just getting started in the
wonderfulworldofoptions.I
will let you mentally digest
that until next time. Optionz
out.
Stock Trader got up
for an energy drink, but sat
back down at the computer a
minute later. Optionz was
right;hereallydidhavealot
to digest. Every option had a
twin. Every option, and even
stock positions, could be
createdsynthetically.
To top it all off, just
whenhewasthinkinghewas
getting to know all of the
option strategies he would
need, Optionz goes and says
that there are many Spread
strategiestolearn.
Whatwerethey?
He needed to look
themup.
He did a Google
search and quickly found a
link to a site that listed a
whole host of option
strategies.
Sure enough, there
wastheCalendarSpreadthey
had talked about. There were
also Vertical Spreads, Ratio
Spreads, Butterfly Spreads,
and Condors. A Strip and a
Strap; what the heck could
thatbe?Guts?Ladder?
“Wow, he was right.
We truly are just getting
started,”hethought.
Stock Trader was
looking through all of the
strategies when something
caught his eye – an
advertisement for a credit
cardwithbonusairlinemiles.
He suddenly realized that he
had been so busy talking to
Optionz over the past month
thathehadforgottentobook
the airline ticket for his
vacation. “Crap. I only get
one two-week vacation a
year,” he said out loud. “I
hopetheyaren’tsoldout.”
“Withonlytendaysto
go until my vacation starts,
evenifIcanfindtickets,they
will be overpriced,” he
thought.
Sure enough, there
were still tickets available,
but at much higher prices
thanhewouldhavepaidifhe
had booked the flight weeks
ago. “$1,000 for the round
trip; I guess I don’t have a
choice,” he thought. “It’s too
late to get a refund on the
hotel room.” He clicked the
‘buy’ button, finished his
energy drink, and was off to
dosomeerrands.
Chapter12
SPREADS:
RATIO,
CALENDAR,
DIAGONAL
No
alarm
this
morning.StockTraderlooked
at his cell phone. It was 8
a.m.andhefeltrested.
His morning ritual
was to get quotes on his
phonebeforeheevengotout
of bed, but there were no
quotes on Saturdays. It had
been an exciting and fastpaced week in the financial
markets. He had taken short
positions and done very well
as the market trended lower.
Itwasnothisfavoritewayto
make money, but he would
takeit.
Now, with the market
well beneath its 200-day
movingaverageandeventhe
best of stocks at or below
their own 200-day moving
averages,
the
market
appearedtobeperchedonthe
edge of a cliff ready to roll
over into the abyss. Where
wouldthenextsupportforthe
market be, the 350-day
moving average? Would it
fallallthewaytothe600-day
moving average? It was
lookingbleak.
He was sure Optionz
probably had on some lowrisk high-probability trade he
had built. Learning these
newest synthetic and Spread
strategies made him think of
Optionz in a laboratory, like
Dr. Frankenstein bringing a
monsteralive.
He
needed
more
option knowledge if he was
going to be able to transition
intooptiontradingoratleast
dabble in it when stock
trading just wasn’t diverse
enough to take on the more
complicated bets he saw an
opportunitytomake.
Would Optionz be
conducting class on a
Saturdaymorning?
Again Optionz was
online, and again he was
engaged in a conversation
with Rookie. “I wonder how
long it will be before Rookie
mentions another Holy
Grail?”hethoughttohimself.
Rookie Trader: So a
Vertical Put Spread is much
safer?
Optionz Traderz: Yes,
Covered Calls expose you to
the
entire
downside
movement of the underlying
stock price; a Vertical Put
Spread only exposes you to
the difference in the strike
prices.
Rookie Trader: So if I
wantedtosellaCoveredCall
on Caterpillar, I would be
better off selling a Put
Spread?
Optionz Traderz: Not
necessarily better off. Each
strategyhasitsownrisksand
potential rewards. All I’m
suggesting is that a Put
Spread has much less risk.
Forexample,withCaterpillar
tradingat$94,sayyoucould
sellaPutatthe$92.50strike
for$5.90andbuyaPutatthe
$90 strike for $4.90. On one
contract of 100 shares, you
wouldcollect$1.00pershare,
or$100.Aslongastheprice
stayed above $92.50 at
expiration, you would keep
the $100, and as long as it
stayed above $91.50, you
wouldhaveaprofit.
Rookie Trader: Wouldn’t I
lose money if the price went
below$91.50?
Optionz Traderz: Yes, you
would, but your loss would
be limited by the Long Put.
Once the price fell below
$90, the Put you bought at
that strike would pick up the
entiremoveinintrinsicvalue.
So if that happened, the
increase in intrinsic value of
theLongPutwouldoffsetthe
increase in intrinsic value of
the Short Put. If the price
stayed below $90 at
expiration, you would buy
100 shares of Caterpillar at
$92.50andsell100sharesfor
$90. You would lose $250,
but get to keep the $100
credityoureceivedwhenyou
openedthetrade.
Rookie Trader: I see. The
maximum amount I could
lose would be $150. That
reallydoesseembetterthana
CoveredCall.
OptionzTraderz:Iwouldn’t
sayit’sbetter,justlessrisky.
If you sold a single Covered
Call at the $90 strike for
$8.90, you would collect
$890 in premiums, but you
would own the entire
downside risk below $90,
with only the premiums you
receivedtooffsetyourloss.
Rookie Trader: So I guess
Vertical Spreads aren’t the
Holy Grail either. I could
make a lot more money
selling a Covered Call, but I
could lose a lot more than
sellingaPutSpread.
StockTrader:2minutesand
10 seconds. I think that may
beanewrecordforthetimeit
took to mention the Holy
Grail.
Optionz Traderz: LOL,you
weretiminghim?
Stock Trader: Yes, but it
looks like you’re making
progress in getting him to
understand a little bit about
howalloptionsinvolverisk.
Rookie Trader: The two of
youreallyshouldgetaroom,
the way you always get
together to gang up on me.
But thanks for the help with
VerticalSpreads.
Optionz Traderz: You are
welcome. However, there are
more Spreads than just
Verticals.
StockTrader: That’s what I
wanted to ask you about.
After we talked last time, I
looked up option Spread
strategies and there are a lot
ofthem.
Optionz Traderz: It might
seem like a lot, but many of
them have similar behaviors
so it isn’t necessary to
memorize each one. Once
you learn the basic Spread
strategies,youwilllikelyalso
understandthemorecomplex
ones. Most complex Spreads
are nothing more than
modifications
of
basic
Spreads.
Stock Trader: So what
Spreads should I concentrate
onstudying?
OptionzTraderz:Well,first
there are three types of
Spreads:netcredit,netdebit,
and net even. Every Spread
you open fits into one of
these
three
categories.
Spreadsarecreatedwhenyou
purchase one option and sell
one option to create a spread
in price between the one you
soldandtheoneyoubought.
Since they differ in price
three scenarios can occur.
You will either receive more
premiums than you are
paying out, ending up with a
netcredittoyouraccount;or
you will pay out more
premiums than you receive,
so your account will have a
net debit. You could also
have an option trade where
the amount of the premiums
will be equal, a net even
trade.
StockTrader:Wait,howcan
Ihaveaneteventradeunless
I sell the same option I am
buying?
Optionz Traderz: I think I
can explain. Let’s start with
the simplest Spread, a
Vertical Spread. A Vertical
Spread is just a fancy name
foratradewhereyoubuyan
option at one strike and sell
an option with another strike
andthesameexpiration.
Stock Trader: That one
makes sense to me. If Apple
is at $375 and I think the
pricehasfoundsupport,Ican
buy a $375 Call for $13.00
and sell a $390 Call for
$6.50, both with December
expiration. I make a profit as
long as the price goes up
enough to cover the
difference in premiums, the
netdebit.
Optionz Traderz: O.K., so
what if you bought one $375
Call, but sold two $390
Calls?
Stock Trader: I would pay
$13.00fortheLongCalland
receive $13.00 for the two
Short Calls. So I would have
a profit as long as the Short
Callstrikewasn’thit?
Optionz Traderz: Actually,
the range of profitability
wouldextendwellbeyondthe
ShortCallstrike.Ifitwashit,
you would have intrinsic
value in the Long Call, from
$375 on up. At prices above
$390, the intrinsic value of
one of the Short Calls would
increase by the same amount
as that of the Long Call.
However, you would have
$15 of additional intrinsic
valueintheLongCall.
Stock Trader: I see what
you’re saying. I would only
be exposed to upside risk on
oneoftheShortCalls,sothe
breakeven point would be
$15 above the $390 strike at
$405.
Optionz Traderz: Exactly,
and that’s all there is to a
Ratio Spread. It is nothing
more than a Vertical Spread
usingaratioofoptionsthatis
anything other than one-toone. It doesn’t necessarily
need to be a net even trade
like the one I described on
Apple.RatioSpreadscanalso
be net debit or net credit
trades.
Stock Trader: I thought
Synthetic Stock was a great
idea, but Ratio Spreads seem
justaspromising.IfIbought
one Call at support and sold
two Calls at resistance, and
was able to open it exactly
net even, I would only lose
the commissions if the price
fellthroughsupport.
Optionz Traderz: That is
one of the great things about
RatioBullCallSpreads;they
are very low risk when the
price falls through support.
Also, if the price did break
throughresistance,youcould
buy the underlying shares.
Doing so would turn one of
theShortCallsintoaCovered
Call, and the intrinsic value
of the remaining Short Call
would give you a nice buffer
foryourstoploss.
Stock Trader: This seems
liketheultimatewaytotrend
trade. If I thought $390
representedresistanceandthe
price shot through to $395, I
could buy 100 shares and set
a stop loss at $390. If the
trendreversed,Iwouldbeout
$500,butstillturnaprofitas
long as the Long Call in my
Ratio Spread expired with at
least$5ofintrinsicvalue.
Optionz Traderz: The only
real risks with this style of
managing a Ratio Spread are
that the price gaps up or it
breaksthroughresistanceand
thenbeginstowhipsaw.Even
so,withtheunderlyingApple
shares at $390, there would
still be $15 of intrinsic value
in the Long Call. You might
get another chance to be
stopped out with a $5 loss
and still manage to break
evenonthetradeasawhole.
Stock Trader: So a Ratio
Spread is like whipsaw
insurance?
OptionzTraderz:That’sone
waytolookatit.Youwould
also have the choice of
simply buying one of the
Short Calls if Apple hit the
$390 strike. Even if it
happened immediately after
opening the trade, it would
likelyonlycostyou$13.00to
buy it back, a $6.50 loss.
What you would be left with
would be a basic Vertical
Spread. However, instead of
paying a $6.50 net debit to
open the Spread when all of
the options were out-of-themoney, you would be paying
theequivalentofthesamenet
debit for a Spread that was
completelyin-the-money.
Stock Trader: I guess it
wouldberareforthepriceto
hit resistance that quickly, so
I would probably pay even
less than $13.00 because in
the meantime there would be
some time decay. Plus,
Implied Volatility might be
lower if the stock was
showing enough strength to
climb to that price level. The
combination of Theta and
Vega could cause the
premiumtobemuchlessthan
$13.00.
Optionz Traderz: Correct.
Also, you don’t need to limit
yourselftoatwo-to-oneratio.
Depending on the strike
prices you choose, you can
choosethree-to-one,three-totwo,oranyothercombination
that gives you the debit or
credityouareseeking.
Stock Trader: So how do I
choose between debit, credit,
oreven?
Optionz Traderz: With
Ratio Debit Spreads, there is
upside risk as well as
downside risk. Lowering the
net debit decreases your risk
ifthetrendgoestheopposite
way you expect, but only by
adding risk in the other
direction. If you lower it all
the way to zero or net even,
you eliminate the risk in one
directionentirely,butonlyby
adding it to the other side. If
you keep lowering it by
making it a net credit trade,
theriskinonedirectionisnot
only eliminated, but profit
potential is added, again by
addingmoreriskintheother
direction.
Stock Trader: That makes
sense. So I need to decide
whether the potential profit
and risk in one direction are
justified by the potential
profit and risk in the other
direction.
Optionz Traderz: That’s all
there is to it. If the economy
isshowingweaknessbutyou
havefoundacompanythatis
doing well in spite of the
conditions, a net even or net
credit Ratio Call Spread
would protect you in the
eventyourstockgotweighed
down by a downturn in the
broadermarket.
StockTrader:That’sagood
point. I could still make a
profit if the company
continued to do well, but I
wouldn’tbetakingontherisk
of a recession or some other
eventthatwasbadenoughto
affectallcompanies,eventhe
strongestperformers.
Optionz Traderz: Ratio
Spreads can be tailored to fit
almostanymarket.RatioBull
CallSpreads,thosewithlong
optionsatalowerstrikeanda
greater number of long
options at a higher strike,
tend to work better in bull
markets as net debit trades
than those opened with a net
credit, due to the increased
upside protection. The same
is true of net debit Bear Put
Spreadsinabearmarket.
Ratio Bull Call Spreads
opened with a net credit can
work well on stocks that are
doing well when the rest of
the market is not. If the
generaldowntrendeventually
begins to have an effect on
the price of an individual
stock, the net credit might
stillresultinaprofit.
Net Even Spreads are good
when there is a high level of
uncertainty in the market. In
the past, I have used Ratio
Put Spreads around earnings.
Sometimes I buy at-themoney Puts and sell enough
out-of-the-money Puts to
balance the premiums. If the
underlying price takes off
after the report, everything
expires worthless and I’m
only out the commissions.
When
earnings
are
disappointing, I profit from
the Long Put, all the way
down to the strike of the
Short Puts. When everything
expires, I end up buying the
underlying
shares
and
keeping the profit on the
Spread.
StockTrader:Wouldn’tthat
also work if I sold a Put atthe-money and then used the
premium to buy out-of-themoney Puts? It seems like it
would be the same, except I
wouldn’t have any downside
risk.
Rookie Trader: Now who’s
lookingfortheHolyGrail?
OptionzTraderz:LOL,he’s
got you there! There is some
downside risk because the
short option can be in-themoney when it expires while
the long options expire
worthless. However, if you
open the trade very close to
the earnings report, there
won’tbemuchtimedecay.If
the short option ends up inthe-money after earnings,
even if the long options did
not have any intrinsic value,
they could increase in time
value. If that was the case,
you could close the trade
soon after earnings were
released and might get out
withasmalllossandpossibly
a small profit. It would
depend on whether the
increaseinfearoverthepoor
report was enough to offset
the decrease in volatility due
to the disappearance of
uncertaintyaboutthecontents
ofthatreport.
Stock Trader: So the risk is
small, but there might be
times when I could still be
able to get out with a profit,
even when the underlying
price moved to a point that
wouldbealosingscenarioat
expiration. Some might
consider that to be a Holy
Grailofsorts.
Optionz Traderz: I guess
you’reright.Thereisanother
use for Ratio Spreads; they
can help you recover from a
poorly performing stock
trade.
Stock Trader: Now this I
havetosee!AreyousayingI
can own a stock that has lost
valueandthenuseoptionsto
turnaloserintoawinner?
Optionz
Traderz:
Anything’s possible, but it’s
more likely you could cut
your loss enough to break
even if the conditions were
right.
StockTrader:Goon.
OptionzTraderz:O.K.,let’s
sayyoubought100sharesof
Apple last summer when the
price broke through the $400
resistance level. If you held
them into November, they
wouldonlybeworth$375,so
you would have a loss of
$2,500 if you sold them.
Assumingthepricehadfound
support at $375, rather than
hold on and wait for a
rebound, you could open a
net even Ratio Bull Call
Spread.Ifyouboughtoneinthe-money Call, at the $355
strike for $26, and sold two
at-the-money Calls at the
$375strikefor$13,bothwith
December expiration, how
wouldthetradeplayoutifthe
underlying price remained
justabovethe$375support?
StockTrader: Let me see…
Everything would expire inthe-money, so I would buy
100 shares at $355 and sell
them for $375, and I would
sell the shares I already
owned for $375. So I would
make a $2,000 profit on the
sharesIboughtwiththeLong
Call and lose $2,500 on the
sharesIalreadyowned.
Optionz Traderz: Yes, so
yourcombinedlosswouldbe
$500, still much better than
the $2,500 loss you would
haveneededtotaketogetout
ofthetradewithoutusingthe
RatioSpread.Thismayseem
like a great way to recover
from a big loss, but it only
workswhenastockhastruly
found support. The Ratio
Spread I described would do
nothing to provide any
protection if the underlying
price fell through support. It
onlyworkswhenpriceshave
fallenandthenstabilized.
StockTrader:Iwouldnever
have thought to use Ratio
Spreads on stocks I already
own.Greatadvice,asalways!
Optionz Traderz: There is
another form of a Ratio
Spread called a Ladder. The
onlydifferencewithaLadder
isthatalloftheoptionshave
different strike prices. For
example,aLongCallLadder
would be opened using a
Long in-the-money Call, but
rather than selling two Calls
at-the-money,onlyonewould
be. The second Short Call
would have a strike out-ofthe-money.Dependingonthe
strike prices and Implied
Volatility,aLongCallladder
mightbeanetcredit,debit,or
even trade. Given the higher
strike price of the second
ShortCall,itmaybepossible
to reduce some of the upside
risk when compared to a
traditional Ratio Bull Call
Spread.Youcanalsocreatea
Short Call Ladder by just
exchangingthelongandshort
positions.Ladderscanalsobe
opened using Puts instead of
Calls.
Stock
Trader:
That’s
interesting, a Ladder can
sometimes work as well as a
RatioSpread,butwithalittle
lessrisk.
Optionz Traderz: It all
depends on the premiums at
the particular strike prices of
theoptionsyouaretrading.If
you are considering a Ratio
Spread, it is often worth
comparing it to a Ladder
before opening the trade to
see which one is the better
choice. If you do compare
them, don’t forget to include
the additional commissions
andfeesinyourcalculations,
aswellasslippageduetothe
bid/askspread.
Stock Trader: Yes. Those
commissions, fees, and
liquidity risks can be silent
butdeadly.
Optionz Traderz: So now
that you know how to use
Ratio Spreads, we can move
on to Calendar Spreads. Like
we talked about last time,
CalendarSpreadsarenothing
more than trades using two
options with the same strike
price and different expiration
dates.
Stock
Trader:
You
mentioned that Calendar
Spreadscouldbeusedwhena
stock was going through a
periodofconsolidation.
Optionz Traderz: That is
correct. The only way a
CalendarSpreadcanresultin
a loss is if the long option
loses more time value than
theshortoption.Sayyousell
a near month at-the-money
Call and buy another Call at
thesamestrikeafewmonths
out. If the underlying price
breaksout,ineitherdirection,
thelongoptioncanlosemore
time value than the short
option.
StockTrader:I’mnotsureI
understand that. Isn’t Theta
thehighestinthefinalmonth
of a contract? If the Short
Call expired with intrinsic
value, I would also have the
same amount of intrinsic
valueontheLongCall,plusI
would still have the
remainingtimevalue.
Optionz Traderz: It can be
confusing. So I like to think
ofitthisway.Thereareonly
three major influences that
can cause an option to
experience a change in time
value: Implied Volatility,
time,andmoneyness.
Stock Trader: O.K., I’m
withyousofar.
Optionz Traderz: Volatility
normally has a greater effect
onthelongertermoptionofa
Calendar Spread, but it also
hassomeeffectontheshorter
termoption.Theresultisthat
most of the time changes in
volatility will have minor
effectsonthecombinedvalue
ofaSpread.
StockTrader:Soweareleft
with time and moneyness as
factors?
Optionz Traderz: Those are
usually the two most
importantinfluences.Youare
correct that Theta causes the
greatestamountoftimedecay
in the final month of a
contract,butthateffectcanbe
overshadowed by the change
in moneyness of the longer
term option of a Calendar
Spread.Ifthatoptionendsup
deepin-the-moneyorfaroutof-the-money it could lose
most or all of its time value.
Because it had a greater
amountoftimevaluethanthe
shorter term option when the
trade was opened, it is also
possible for it to lose more.
Thelossoftimevalueonthe
longer term option due to
changesinmoneynesscanbe
greater than the loss of time
value of the shorter term
optionduetotimedecay.
Stock
Trader:
If I
understand correctly, the
options with longer time to
expiration
have
higher
premiums because there is
more uncertainty about what
the price of the underlying
willbewhentheyexpire.But
iftheunderlyingpricemoves
violently in one direction or
the other, they might either
end up so deep in-the-money
thattheywillbetradingatpar
withtheunderlyingshares,or
theywillbesofarout-of-themoney that they will be
nearly worthless. In either
case,theywillhaveverylittle
time value. Meanwhile the
optionswithnearerexpiration
will expire with intrinsic
valueonly,havinglost100%
of their time value. The
intrinsic values of the long
and short options in a
Calendar Spread are always
the same, so if I lose more
time value on the long
options than I gain on the
short options, I will
experiencealossonthetrade.
Optionz Traderz: You’ve
got it. You can also do a
Calendar Spread trade in
reverse – buy a near month
optionandsellafarmonth.If
the moneyness of the far
monthoptioncausesittolose
moretimevaluethanthenear
month option loses due to
Theta,youwillhaveaprofit.
StockTrader:SoaCalendar
Spread with long options in
thenearmonthisbettingthat
a breakout will cause
consolidation to end, and the
same Spread with the short
options in the near month is
bettingthatconsolidationwill
continue.
Optionz Traderz: Both can
work well if either scenario
plays out. But both strategies
depend on the same initial
setup; the stock is going
throughaconsolidationphase
whenthetradeisopened.Ifa
stock is in a strong trend, a
Calendar Spread is usually
notthebestchoice.
Stock Trader: I think I see
where you are going with
this. If a stock is in a strong
trend,aCalendarSpreadwith
the long options having a
shorter term than the short
options might result in a
profit, but a Vertical Spread
or a Ratio Spread could be
much more efficient at
capturingthetrend.
Optionz Traderz: As I
mentioned earlier, it’s all
about choosing the best tool
forthejob.Whenyouhavea
toolbox full of option
strategies,itismucheasierto
pick the one that will give
you the best results for the
currentmarketconditions.
Stock Trader: So a Vertical
Spread is best when a strong
trend is likely, but there is a
risk of loss if the trend goes
in the wrong direction. A
Ratio Spread can be used to
profit from a trend with little
or no risk if a trend fails to
develop or if it reverses, but
there is a risk of loss if the
magnitude of the trend does
not meet expectations. And a
CalendarSpreadisbestwhen
a stock is going through
consolidation, but there is a
risk of loss if the prediction
of whether or not a breakout
willoccuriscorrect.
Optionz Traderz: You can
also combine strategies. For
example, you can combine a
Calendar Spread and a
VerticalSpreadtoformwhat
is known as a Diagonal. In a
Diagonal Spread, you are
trading options with two
different expirations at two
differentstrikeprices.
StockTrader:SoifIbought
November Calls on Apple at
the $375 strike and sold
December Calls at the $390
strike, that would be a
DiagonalSpread?
Optionz Traderz: It’s that
simple. Diagonal Spreads are
meanttocaptureatrendwith
limited upside and downside
risk. The difference between
aregularVerticalSpreadand
aDiagonalisthatthefarterm
options
have
higher
premiums than the near term
ones.Thatgivesyouachance
toopenthetradeverycloseto
net even, something that is
not possible with either a
VerticalSpreadoraCalendar
Spread. Just as with a net
even Ratio Spread, if you
open a net even Diagonal
Spreadandthetrendgoesthe
wrong way, your loss is
usually limited to the
commissions.
Stock Trader: So when
wouldbeagoodtimetousea
DiagonalSpread?
OptionzTraderz: Iknowof
some traders who use
Diagonals as an alternative
for Covered Call writing. By
buying a near month at-themoney Call and selling an
out-of-the-moneyCallforthe
followingmonth,theresultis
atradethatbehavessimilarly
tothatofaCoveredCall,but
without as much downside
risk. If the underlying price
falls considerably, there is a
chance that both options
could eventually expire
worthless. If the price rises
andthenearmonthLongCall
is exercised, the trade truly
doesbecomeaCoveredCall.
Theonlydifferenceisthatthe
stock was purchased in a
bona fide uptrend, at a
bargain price that was
determinedbythestrikeprice
oftheLongCall.
Stock Trader: That seems
like another option strategy
thatwouldworkwellwithmy
trend trading system. If the
Long Call is exercised, I not
only get to keep the full
amount of any move, up to
the strike price of the
followingmonth’sShortCall,
but I also have a cushion on
the downside, having bought
the shares at the strike price
oftheLongCall.
Optionz Traderz: The good
newsisthatSpreadsarevery
slow to react to changes in
the underlying price. Unlike
stock trading, where your
account changes value with
every tick, Spreads can take
days or weeks to show any
real movement. Even when a
trade goes against you, the
slow pace may give you the
time you need to re-evaluate
thetradeandcutyourlosses.
Stock Trader: I really like
the idea of using Spreads as
whipsaw insurance. In my
stock trading system, I often
get stopped out of an
otherwise good trade when
whipsaw trips my sell order.
As disappointing as it is to
get stopped out early, my
systemrequiresthatIalways,
always,honormystops.With
the value of a Spread being
much more stable than the
underlying stock, I should be
able to reduce my whipsaw
losses.
Optionz Traderz: Option
strategies can be tailored to
almostanytradingmethod.If
controlling whipsaw losses is
a major goal, then Spreads
canbeveryhelpful.
Stock Trader: I wish I had
known about Spreads back
when the Dow was making
hourly triple digit swings a
while back. I opened several
trades that week, and every
oneofthemgotstoppedout.
Optionz Traderz: Ouch!
That’s something you’ll
rarely see in the world of
options, if you are careful to
set up your trades in a way
that minimizes your risk. I
onlykeepahandfuloftrades
running at any given time,
and there are some weeks
when I don’t need to place
anytradesatall.Infact,when
themarketwasperformingits
recentstunts,Iwassittingby
the pool, confident that my
option strategies would be
unaffected.
Stock Trader: Any other
thoughtsonSpreadtrading?
Optionz Traderz: There are
manySpreadstrategies,buta
lot of them are just altered
versions of the ones we have
already discussed. There
reallyisnoneedtomemorize
them,butitmaybehelpfulto
see the wide range of option
combinations available. Here
areafewofthem:
Guts:Thisstrategyisnothing
more than a Strangle, but
with a Long Call and a Put,
both in-the-money, with the
sameexpiration.Itwillturna
profit only when a very
strong trend develops. A
ShortGutsisjusttheopposite
– a Short Call and Put, both
in-the-money.Inmyopinion,
aGutstradeisnobetterthan
a Strangle. The amount of
intrinsic value gained on the
Call will be lost on the Put
untilthePutstrikeishit,and
viceversa.Profitsdonotstart
until the underlying price
goes beyond one of the
strikesbyanamountequalto
thecombinedtimepremiums,
the same as with a Strangle.
The only difference is that a
Gutstradehasabetterchance
of both options expiring inthe-money,
requiring
additional commissions. Just
as with Strangles, Long Guts
trades are trendish strategies
and Short Guts trades are
rangeboundstrategies.
Ratio Write: This is one of
those trades that can be
simplifiedusingsynthetics.A
Ratio Call Write involves
buying 100 shares of stock
and then selling two at-themoneyCalls.Tosimplifyit,it
can be broken down into a
Covered Call and a Short
Call. The synthetic position
for a Covered Call is a Short
Put, so the trade becomes
equivalenttoaShortPutand
ShortCall–aShortStraddle.
Interestingly, a Ratio Put
Write, which is opened by
shorting 100 shares of stock
and selling two at-the-money
Puts, also breaks down to a
Short Straddle when the
synthetic
positions
are
substituted. Because they are
both equivalent to a Short
Straddle,theybothworkbest
ontightlyrangeboundstocks.
Variable Ratio Write: For a
Variable Ratio Call Write,
100 shares of stock are
purchased, followed by
sellingonein-the-moneyCall
and one out-of-the-money
Call. The stock combined
with the in-the-money Short
Call is equivalent to an outof-the-money Short Put.
Combining an out-of-the-
moneyShortPutwiththeoutof-the-money Short Call is
the equivalent of a Short
Strangle. Just as the Ratio
Call and Put Write are
identical,aVariableRatioPut
Write is the same as a
Variable Ratio Call Write.
BothareequivalenttoaShort
Strangle, and both would be
appropriate for a moderately
rangeboundstock.
Strip: This strategy is a ratio
versionofaStraddle.Usually
it involves a Long at-themoneyCallandtwoLongatthe-moneyPuts.Soitbehaves
the same as a Straddle, but
with one-third more risk,
which allows it to perform
better in a downturn. Strips
are slightly bearish, strong
trendstrategies.
Strap:AStrapisthesameas
a Strip, but with two Long
Calls and one Long Put, all
at-the-money. Again, it is
slightly riskier than a
Straddle, but performs better
iftheunderlyingstockrallies.
That makes a Strap a strong
trend strategy with a bullish
bias.
Stock Trader: As always,
you’ve given me a lot to
digest. I think I need some
timetowrapmybrainaround
allofthis.
Optionz Traderz: Don’t let
all of the terminology scare
youawayfromSpreads;there
are no set rules for trading
them. Just because a Spread
hasanamedoesn’tmeanit’s
better than one you design
yourself. The most important
thing to remember when you
trade Spreads is that you can
move the risk wherever you
wantit.Ifyoudon’twantany
downside risk, choose a
strategyandstrikepricesthat
eliminatethatriskbymoving
it to the upside. If you want
neither upside nor downside
risk, just move it to the
center.
Stock Trader: The center?
Are you talking about Long
StraddlesandStrangles?
Optionz Traderz: Exactly.
And there are two more
Spreadswheretheriskcanbe
moved to the center:
ButterfliesandCondors.
Stock Trader: And how
many more strategies are
there?
Optionz Traderz: Just
ButterfliesandCondors;after
that,yourtoolboxwillbefull.
Stock Trader: Well, thanks
forthealloftheadviceabout
Spreads. You could write an
option book with all your
knowledge.Goodgrief,Iwill
have to save and read this
conversation thread a few
times to really understand all
thedynamicsofSpreads.This
soundslikehowthebigboys
doit.
Optionz Traderz: Yes,
Spreads done correctly can
lead to income with very
controlled risk. Talk to you
soon.
Stock Trader found
himself sitting at his
computer trying to think
through the option plays that
Optionz had discussed. They
werealittlemindbending.
Buying an at-themoneyCallthensellingtwice
as many out-of-the-money
Calls to pay for the Long
Call? A free Call option as
longastheShortCallsdonot
go in-the-money too deeply.
This was simply amazing to
him.
Buyinganearterminthe-moneyCallthensellinga
longertermout-of-the-money
Call to create a sort of
precursor to a Covered Call
withmuchlessriskofcapital.
These were so mind
bending he felt like he had
taken the red pill and woken
upfromtheMatrix.
Howcouldcombining
options result in completely
different option plays than
what the individual options
represented? By combining
Longs and Shorts, Puts and
Calls you could create what
seemed
like
endlessly
differentoptionplays.
Hewasponderingthis
while sitting at his computer,
sipping his daily requirement
ofcaffeineinliquidform.
Hewaslookingathis
trading records and thinking
about different ways to use
optionstoplaytohisbeliefs.
He wrote notes as he
thought.
Trading in a range
boundmarket:ShortStrangle
soldatresistanceandsupport.
Ahotstockbreaksout
on high volume: At-themoneyCalloption.
The market bounces
off support: At-the-money
Calloption.
Market topping out
and reversing on high
volume:At-the-moneyPuts.
Ifaneventisexpected
thatwillmoveastock,sector,
orthemarketinonedirection
in a big way: A Long
Strangle.
Iwanttoopenatrade
without needing additional
capital: Create a Synthetic
Stock position; Call and Put
at-the-money, one Long, one
Short, depending on the
directionbias.
Iaminvestedinahot
stockIbelievein,butwantto
generate some income:
Covered Calls, write Short
options
out-of-the-money
overandoveragain.
I want to be paid to
buy a stock at the price I
want:WriteShortPutsatthe
strike price I want to pay for
thefavoritestocksonmybuy
list.
Volatilityisveryhigh
butIdon’tbelievethemarket
will really move as much as
is priced-in: A Short at-themoneyStraddle.
He was impressed
with his own list. He had
beenlistening.
As he thought of this
new tool box, he looked at a
boxofbuildingblocksthathe
keptforhisniecetoplaywith
when she visited; they were
theinterlockingkindthatyou
couldbuildthingswith.
As he took a few out
and put them together
absentmindedly, he made a
little dog. He thought for a
minute, “When these blocks
were lying separately in the
boxtheywerejustindividual
blocks,
but
when
interconnected they became
something different. A small
blockbecameanear,slightly
bigger blocks the legs and
head. The blocks did not
change, just how they were
used together did. They were
the same exact block as they
were before, but when put
into position with other
blocks they became a small
partofawholenewthing.”
Stock Trader believed
this had to be like option
strategies, combining options
togethertocreatenewthings.
The options themselves
stayed the same but the
combination made them part
ofanewstrategy.
All this thinking was
stimulating, but at the same
timeexhausting.StockTrader
settledontothecouchforan
afternoon nap. His tickets to
San Diego, California lay
next to him on the coffee
table. As he dozed off,
images of blocks, options,
and beaches danced through
hishead.
Chapter13
THEWIND
BENEATHTHE
PRO’SWINGS:
BUTTERFLIES
AND
CONDORS
Stock
Trader
awakened
on
Sunday
morning, reflecting on the
pleasant Saturday he had
passed. He had done pretty
much nothing but watch a
little television and study
charts of stocks on his watch
list. He had also played on a
few social network sites.
Since he had signed up for
them, they had doubled his
‘wasting’ time on the
Internet. He did enjoy
connecting with likeminded
people, although maybe a
littlebittoomuch.
Hetrulylovedthefact
that he could talk to people
around the world who
thoughtthewayhedid.
He would definitely
be keeping his eye on any
social networking sites that
went public. He believed
social
networking
was
heading into the age of
Internet 2.0, with much of
what excited investors in the
late nineties coming to pass
thistimearound.
Stock Trader believed
eyeballs on the Internet were
beginning to really have true
value, similar to the belief in
thego-goInternetboomyears
thatsawtheNASDAQclimb
to5,000points.
While stumbling onto
Internet friends, he found it
oddthatsomanytraderswere
free market capitalists; many
heldthesamepoliticalbeliefs
ashedid,evenreadingmany
of the same books and
supporting the same political
candidates.
He believed his
communications
with
Optionz Traderz had grown
into a true mentoring
friendship,eventhoughsome
had thought they had a
blossoming‘bromance’inthe
group,whateverthatmeant.
With the markets
closed and Stock Trader
bored of surfing the Internet,
he thought he had done well
tonotbotherOptionzyet.But
by 11 a.m., he could take no
more;itwastimetogetinthe
mix and learn something
aboutoptions.
Stock Trader saw that
Optionz was online. Not
wanting all of the rest of the
group to butt in with
nonsense, Stock Trader sent
Optionz a direct message so
they could chat online
privately.
StockTrader: Hey, how are
youdoingtoday?
OptionzTraderz:Iamgreat,
just catching up on some emailsbeforeIgoforarun.
Stock Trader: Do you have
time now or later to run
throughthelastoftheoption
strategies?
OptionzTraderz:Sure,Iam
innohurry.Ihaveallday.
Stock Trader: What were
the last two strategies you
teasedmewithyesterday?
Optionz Traderz: Correct
meifIamwrong,butIthink
the only two main option
strategies we have not
discussed are the Butterfly
andCondor.
Stock Trader: Yes, the bird
and the bug; you have not
explainedtheflyingones.
Optionz Traderz: LOL, I
haveneverthoughtofthemas
the ‘flying ones.’ That is
funny!
Stock Trader: Most options
and strategies have some
reasoningbehindtheirnames.
A Call option is so named
becauseitenablesyoutocall
astockawayfromsomeone;
aPutoptionallowsyoutoput
a stock on someone; a
Straddle option play allows
youtostraddleapriceinboth
directions;
creating
a
Synthetic Stock position
through a Long and Short
optionmimicstheunderlying
shares. But why name an
optionsstrategyafterabirdor
aflyingbug?
Optionz Traderz: Well, the
reason is that these strategies
havea‘body’ofshortoptions
and ‘wings’ of long options.
The wings ensure that the
losses are controlled if the
option trader is wrong about
the market’s trading range.
CondorandButterflySpreads
arejustcombinationsofatwo
Vertical Spreads. The most
basic of these, a Long Call
Butterfly or Long Call
Condor, is a Vertical Bull
Call Spread combined with a
Vertical Bear Call Spread.
I’m sending you diagrams of
thepossibleprofitsandlosses
atexpiration.Maybethatwill
helpclearthingsup.
Stock Trader: That looks
simple enough. A Butterfly
has a much narrower range
than a Condor where it is
profitable, but the potential
profit is much lower for the
Condor.
Optionz
Traderz:
As
always,it’sallaboutriskand
reward. The higher potential
reward of a Butterfly is
balancedbytheveryhighrisk
of a small loss. The Condor
hasamuchhigherprobability
of turning a small profit, but
that is balanced by a higher
potential loss. The potential
profitandlossisalsoaffected
by the width of the body.
Butterflies and Condors with
wide bodies are much more
likely to return a profit, and
the potential profits are
higher than would be
expected from those with
small bodies. However, the
higher probability and higher
potentialprofitcomeswithan
increaseinthepotentialloss.
Stock Trader: That makes
sense.Doesitworkthesame
way with Puts instead of
Calls? It seems like if I
bought an in-the-money Put
and sold two Puts at-themoney and bought another
Put out-of-the-money, it
would react the same as if I
usedCalls.
Optionz Traderz: That is
correct. Many traders use the
term ‘Butterfly’ to refer to a
Spread formed entirely from
Call options. Others like to
use the term ‘Long Call
Butterfly’ to distinguish it
from the one you described,
whichisoftencalleda‘Long
PutButterfly.’Therearealso
Iron versions that combine
Calls and Puts. The Iron
versions of these are nothing
more than a Short Straddle
surrounded by a Long
Strangle as insurance against
beingwrong.
StockTrader:Iron?Likean
Iron Butterfly or Iron
Condor?
That
sounds
ridiculous but I think I have
heard of an Iron Condor
before. I must have lived a
sheltered stock trading life.
With putting Spreads inside
of other Spreads or Straddles
insideofStranglesitreminds
me
of
Thanksgiving
‘Turducken,’achickeninside
aduck,insideaturkey.
OptionzTraderz:Youcould
saythat,Iguess.
Stock Trader: It is almost
like a football team, with an
offense being the Short side
and the defense being the
Longside.
Optionz Traderz: LOL,you
arereallylettingtheanalogies
fly today. I think you are
accurate in your examples
though.
StockTrader:Ithelpsmeto
grasp your concepts when I
put them in terms I can
understand.
Optionz Traderz: Iron
Butterflies and Iron Condors
don’t
behave
much
differently than standard
Butterflies or Condors. I’m
sendingyouapayoutdiagram
of an Iron Butterfly on
Boeingthatyoucancompare
totheLongCallButterfly.
StockTrader:Iseewhatyou
mean; the profit and loss on
the Iron Butterfly is almost
identical to that of a regular
Butterfly. I guess if the
payouts were very close, it
would make more sense to
use a regular Butterfly
because it would require
fewer trades and therefore
lowercommissions.
Optionz Traderz: It’s
always a good idea to
compare and cut your
commission costs when
possible.
Stock Trader: Any other
ideas?
Optionz Traderz: You
should also consider the
commissions on the closing
trade. An Iron Butterfly will
always expire with at least
one but no more than two
options
in-the-money,
whereas a Long Call
Butterfly can expire with all
options being completely
worthless,orasmanyasfour
optionsin-the-money.
StockTrader:That’sagood
point. Iron Butterflies cost a
little more in commissions at
the open, but can be less
expensivetoclose.
Optionz Traderz: You
should also check your
broker’s
commission
schedule for exercises and
assignments;oftenthecostis
much higher than regular
option trades. If you open a
Long Call Butterfly and the
underlying price suddenly
shoots way up, the options
you traded might lose their
liquidity. In that case, you
wouldnotonlybestuckwith
alosingtradeuntilexpiration,
but also be required to pay
the commissions for two
exercises
and
two
assignments. It could also
come back to haunt you at
income tax time; even if the
exercisesandassignmentsdid
notincreaseyourtaxliability,
it could be an accounting
nightmare.
StockTrader: There you go
again, pouring a bucket of
coldwateronmejustwhenI
was warming up to the idea
of trading Butterflies and
Condors.
Optionz Traderz: Despite
the
downfalls,
many
professionals love these
strategies as a means of
generating consistent returns
in normally functioning
markets. However, they lose
money in strong sustained
trends. It has been my
experience that sustained
trendsoccurabout20%ofthe
time.
That
percentage
provides Butterflies and
Condors with a long term
winning probability of about
80%.Theprofitsaremadein
a price zone, where the price
of the underlying stock does
notmoveconsistentlyinonly
one direction. They do very
well in range bound markets,
sometimes giving the false
appearanceoftheHolyGrail.
Theycanalsobeprofitablein
volatile markets, as long as
the market keeps swinging
anddoesnottakeoffineither
direction.
Stock Trader: So maximum
profits are made if the stock
goes nowhere and ends up at
expirationtradingatthesame
priceasitwasatthetimethe
tradewasopened.Theprofits
aretheshortoptionpremiums
minus the long option
premiums?
Optionz Traderz: Condors
have wider bodies than
Butterflies, hence the name.
They are both structured to
capture profits in a range
boundmarketandatthesame
time have insurance to avoid
any huge losses due to
unexpected epic trends in
eitherdirection.
Stock Trader: And an Iron
Butterfly or Iron Condor is
likeaShortStraddleorShort
Strangle, with insurance both
ways?
Optionz Traderz: What a
Butterfly Spread does is
combineaBullandBearCall
Spread. This option strategy
uses four options at three
consecutively higher strike
prices. For a Long Call
Butterfly,thelowertwostrike
prices are used in the Bull
Call Spread, and the higher
strike price in the Bear Call
Spread. As I mentioned
earlier, Puts can be used
instead of Calls and the
performance is usually
similar. Either way, a Long
Call Butterfly or Long Put
Butterfly strategy has limited
riskbutalsolimitedprofit.
StockTrader:Sortofatrade
forincome,notbigwins.
Optionz Traderz: Exactly.
The Iron Butterfly is also
created with four stock
optionsatthreeconsecutively
higher strike prices. This
option strategy is different
from the standard Butterfly
Spread because it uses both
CallsandPuts,asopposedto
allCallsorallPuts.However,
as you observed on the
payout diagrams that I sent,
the performance of an Iron
Butterflyisoftenverysimilar
to that of a standard Long
CallButterfly.
Thetwooptionslocatedatthe
middle strike in the Iron
Butterfly strategy create a
Short Straddle – one Call
option and one Put option
withthesamestrikepriceand
expiration date. The stock
optionsatthe‘wings’areaare
at higher and lower strike
prices and are created by the
purchase of a Strangle – one
Call and one Put at different
strike prices, also with the
sameexpirationdate.
The Iron Butterfly strategy
does a great job of limiting
theamountofriskandreward
because of the insurance the
Long options give to the
Short positions. If the
underlyingpricefallsduetoa
bigdowntrendinthemarket,
and the investor holds a Short
Straddle at the center strike
price,thepositionisprotected
to some extent, thanks to the
lowerLongPut.Ontheother
hand,ifthepriceofthestock
rises,theinvestorisprotected
bytheupperLongCallacting
asinsurance.
Stock Trader: O.K., I am
going to have to save that
post and read it again. But I
think I understand the
concept.TheLongStrangleis
the body guard of the Short
Straddle, and the Iron
Butterfly Spread makes
money when the underlying
stockisrangebound.
Optionz Traderz: It seems
like you have the basic idea.
A Long Call Butterfly
behavesalmostthesameasa
LongPutButterflyoranIron
Butterfly. The profit and loss
potential on each strategy is
nearly identical, and each
strategy works best when the
market or a specific stock is
range bound. The only major
difference between the three
strategies is the amount of
commissionsrequiredtoopen
andcloseeachtrade.
Stock
Trader:
If
all
Butterflies
are
almost
identical, how would you
suggest choosing which one
to use in order to limit the
amountofcommissions?
Optionz Traderz: That’s a
greatquestion.Butterfliescan
gobble up a lot of
commissions,
sometimes
damaging an otherwise good
trade. For example, take the
ButterflyonBoeingCo.thatI
included in the diagram
earlier. The maximum profit
onthattradeisunder$200.I
know of one ‘discount’
brokerthatchargesabout$10
per option trade and $20 for
exercisesandassignments.So
assuming you chose a Long
Call Butterfly, even if the
underlying price remained a
pennyabovethecenterstrike
at expiration, you would pay
$30 in commissions to open
thethreelegsofthetradeand
another $60 if you allowed
the exercise and assignment
of the in-the-money Calls at
expiration. That $90 would
eat up a big chunk of your
profit.
Stock Trader: I see what
you’re saying. If the
underlying stock closed at a
penny over the center strike
price at expiration, a Long
Put Butterfly would result in
only$50incommissions:$30
to open the trade and $20 to
exercise the single long Put
thatwasin-the-money.That’s
still a lot, but much better
thantheLongCallButterfly.
Optionz Traderz: Yes, so
theLongPutButterflywould
beabetterchoiceifthestock
had found support but
remained range bound, while
the Long Call Butterfly
wouldworkbetterforarange
bound stock that was
hovering near a resistance
level. Both strategies would
perform about the same, but
the commissions could be
muchdifferent.
Stock Trader; I guess I
could also save some of the
commissions if I closed the
tradeonexpirationdayrather
thanallowingittoexpire.
Optionz Traderz: That’s
how the pros do it. Since
Butterflies produce a limited
amount of profit even when
theyworkperfectly,allowing
themtoexpirecouldresultin
unwanted risk that could
quickly erase those profits.
Thinkofitthisway.Assume
you opened that Long Call
Butterfly on Boeing Co. and
allowed it to expire with the
underlying price a penny
above the center strike. Not
only would you pay the
inflated commissions to
exercise the Long Call and
for assignment of the two
Short Calls, you would also
betakingontheaddedriskof
the share price gapping up
beforethemarketopenedthe
following week. Even if you
were lucky enough that the
share price remained steady
ordeclinedovertheweekend
of expiration, you would still
need an additional trade to
covertheshortstockposition
that was created when the
second Short Call was
assigned.
StockTrader:Goodpoint.If
I am only making a $200
profitonatrade,whypay$90
incommissionswhenIcould
cutthatto$60byclosingthe
trade on expiration day? The
addedbenefitwouldbethatI
would get to keep my profits
without risking a loss that
would occur due to an
unfavorable move in the
stock price after-hours on
Fridayorinthepre-marketon
thefollowingMonday.
Optionz Traderz: The same
reasoning applies to a Long
Put Butterfly. Unless all of
the options expired in-themoneyorallofthemexpired
worthless, you would end up
with either a Long or Short
position in the underlying
stock if you didn’t close the
trade before it expired. That
canbeagoodthingifyouare
using Butterflies as a means
of entering a stock trade.
However, if you are trading
Butterfliessimplyforincome,
it usually makes sense to
close them on expiration day
wheneverpossible.
Stock Trader: I think I
understandButterfliesnow.A
Long Call Butterfly would
work best on a range bound
stock that was unlikely to
push through resistance. A
Long Put Butterfly would be
more appropriate for a range
bound stock that was trading
near a strong support level,
and an Iron Butterfly would
also work well on a range
bound stock, but with fewer
trades and commissions
requiredtoclosethepositions
onexpirationday.
Optionz Traderz: The
Condor option strategy also
hasaBearandaBullSpread,
except that all four strike
prices are different.The goal
of the Condor Spread is to
trade the higher potential
profits of a Butterfly for lower
sensitivity to small market
movements, but with a
slightlyhigheramountofrisk
than a Butterfly. As with
Butterflies, Condors can be
created using all Calls or all
Puts,andthemaindifference
between the two strategies is
the amount of commissions
requiredtoclosethetrades.
The Iron Condor is also
created by trading four
different
options
with
differentstrikeprices,butitis
composed of two Calls and
two Puts. In the Iron Condor
you are holding long and
short positions in two
different Strangles. The
potential for profit or loss is
limited in this strategy
becauseanoffsettingStrangle
is positioned around the two
options that make up the
option Strangle at the middle
strikeprices.
This strategy is used when a
traderbelievesthemovement
of the underlying stock will
be range bound within the
Stranglestrikeprices.AnIron
Condor is very similar in
structuretoanIronButterfly,
but the two options located
near the center of the option
strategydonothavethesame
strike prices like they do in
the Iron Butterfly. Having an
option Strangle instead of a
Straddle at the two middle
strike prices widens the area
for profit,butatthesametime
makes the potential profits
lower.
Stock Trader: These are
some of the most interesting
of all the option strategies
you have shared. Very
fascinating, low risk, and
could generate consistent
profits.
Optionz Traderz: Like with
all option strategies you will
have to be mindful of
liquidity in your options and
commission costs. With four
options to buy and then sell,
you want to ensure that you
still have profits to make it
worth your while after
accountingforthelossofthe
bid/ask spread and possibly
paying eight commissions to
enterandexit.Thisstrategyis
used
best
with
low
commission costs and traded
with size that makes it worth
thetrader’stimeandeffort.
Stock Trader: So that’s it.
Butterflies
and
Iron
Butterfliesforatightlyrange
bound stock, and Condors
andIronCondorsforawider
range of profitability. I’ll
have to read through your
postsagaintoreallywrapmy
head around these strategies,
but I think I have a good
understanding of how they
work now. Thanks for your
help.
Optionz Traderz: I don’t
mean to scare you, but there
are still six more strategies
foryourtoolbox.
Stock Trader:
joking,right?
You’re
Optionz Traderz: LOL, I’m
notjoking.Butthegoodnews
is that they are all related to
the Butterflies and Condors
wehavealreadydiscussed,so
they won’t take long to
explain.
Stock Trader: O.K., go
ahead.
Optionz Traderz: As you
noticed, Butterflies and
Condors work well on range
boundstocks.Justaswithall
oftheotheroptionstrategies,
there is an opposite strategy
that works well under the
oppositeconditions.
Stock Trader: That makes
sense. So what would be the
oppositeofaButterfly?
Optionz Traderz: Many
tradersrefertosuchastrategy
asaReverseButterfly.There
is also a version called the
Reverse Iron Butterfly. The
samegoesforCondors;there
are Reverse Condors and
ReverseIronCondors.
Stock Trader: I’m guessing
by the name ‘Reverse’ that
theyworkbestonstocksthat
arenotrangebound.
Optionz Traderz: Exactly.
To create the Reverse
Butterfly or Condor, all that
needstobedoneisswitchthe
long and short positions. For
example, a Long Call
Butterfly consists of Long
Calls at the wings and Short
Callsinthecenter.AReverse
Butterfly,whichissometimes
called a Short Call Butterfly,
is formed with Short Calls at
the wings and Long Calls in
thecenter.
Stock Trader: So a Reverse
Butterfly results in a profit if
the underlying stock price
movesoutsideofaverytight
range?
Optionz Traderz: That’s all
there is to it. With a Reverse
Butterfly created using all
Calls, it is like selling a Call
Spread and buying a slightly
less expensive Call Spread;
thetraderesultsinasmallnet
credit. If all of the options
expire worthless, the trader
gets to keep the net credit,
andifalloftheoptionsexpire
in-the-money, the trader is
left with a Vertical Bull Call
Spread with profits that
exactlycancelthelossonthe
Vertical Bear Call Spread,
again keeping the net credit.
Theonlylosingscenariofora
Reverse Butterfly occurs
when the underlying price
remains
unchanged
at
expiration.
Stock Trader: That seems
like a great way to generate
income, so there must be a
downside you are about to
mention.
Optionz Traderz: You
knowmetoowell.Intheory,
ReverseButterfliesareagreat
wayofgeneratingincomeno
matterwhichwaythemarket
moves. However in practice,
the income is rarely enough
to offset the commissions. If
you look at the Boeing Co.
Butterfly diagram again, you
willseethatopeningthetrade
in reverse would result in a
maximum profit of just over
$50. That hardly justifies the
risk of a maximum loss of
nearly $200, even before
commissions are considered.
To turn a profit, the number
ofcontractsusedwouldneed
to be large enough to offset
thecommissionsandfees.
Stock Trader: That diagram
really helps. If I trade a
Butterfly on Boeing Co., I
haveachancetomakea$200
profit using just four option
contracts,sothatwouldcover
the cost of the commissions;
but if I trade a Reverse
Butterfly,the$50profitcould
be
entirely
lost
to
commissions
unless
I
increasedthetotalnumberof
contracts.
Optionz Traderz: You’ve
got it. It is very important to
consider your position size
when
trading
Reverse
Butterflies in order to ensure
thatcommissionsdonotsteal
all of your possible profits.
Just as with regular
Butterflies,
Reverse
Butterflies can be created
three ways. They can be
openedwithallCalls;aShort
Call Butterfly, all Puts; a
ShortPutButterfly,oraLong
Straddle surrounded by a
Short Strangle; a Reverse
IronButterfly.
Stock Trader: That makes
sense.Somychoiceofwhich
strategytousewoulddepend
on whether I thought the
stockpricewasmorelikelyto
go up or down. A Short Call
Butterflycouldhaveallofthe
options expire worthless if
the stock price dropped, a
Short Put Butterfly could
havealloftheoptionsexpire
worthless if the stock price
climbed, and a Reverse Iron
Butterfly would guarantee
that no more than two of the
optionswouldrequireatrade
toclosethematexpiration.
Optionz Traderz: It’s as
simple as that. All three
strategies
have
similar
behaviors, so it is the
difference in commissions
that sets them apart. The
same is true of Reverse
Condors. The Short Call
Condor requires no closing
trades when the underlying
shares fall below the lowest
Call strike, the Short Put
Condor expires with all
options worthless when the
underling price rises above
thehighestPutstrike,andthe
Reverse Iron Condor always
expires with at least one
option,butnomorethantwo
requiringaclosingtrade.
Stock Trader: You were
right; those six strategies are
not
that
difficult
to
understand.
OptionzTraderz:I’mgladI
could
help.
Reverse
Butterflies and Condors can
be particularly useful when
there is pending news
surroundingacompany,such
as an upcoming earnings
report. Unlike a Long
Straddle,whichcancapturea
strongmovethatresultsafter
earnings are released, a
Reverse Butterfly or Condor
will not change in value
significantly due to the
collapse in volatility that
often
occurs.
Implied
Volatility has an effect on
both the long options and
short options in a Butterfly
Spread, so even when
volatility does decrease after
an earnings report, it usually
haslittleoveralleffect.
StockTrader:That’sagreat
idea, using a Reverse
Butterfly to capture a move
caused by an earnings report
without the volatility risks
involvedinaLongStraddle.
Optionz Traderz: Another
niceaspectaboutallSpreads,
especially Butterflies and
Condors, including the
Reversevarieties,isthatthey
normallyreactveryslowlyto
changes in the underlying
price. But that’s a topic for
anotherday.Iwanttogetout
andenjoythisniceweather.
StockTrader:Gotit.Thanks
forthatlastpieceofthe
puzzle
concerning
optionstrategies.
OptionzTraderz:O.K.,now
it is time for a run on the
beach.IwillseeifIcanbeat
mybesttime.
Optionz Traderz is now
offline……
Optionz’s generosity
never stopped amazing Stock
Trader. He smiled at the
thought of Optionz’ beach
run; he himself would soon
get to be ocean side on his
upcoming, much-deserved
vacation. He was really
looking forward to enjoying
some hot weather and
meeting up with his old
college roommate, just as he
had done most every autumn
since graduation. But until
that day came, it would be
back in traffic tomorrow
morning.
“Good grief!” The
verythoughtofthe9-5grind
madehisspiritfall.
Chapter14
DEALING
WITHTHE
BEHAVIORAL
PROBLEMSOF
IMMATURE
OPTIONS
“71
degrees
Fahrenheit in Sunny San
Diego,California”iswhathis
smart phone said. A smile
cameacrosshisface.
“Nice.”
With a week to go
before he took off, he began
hisannualdaydreamingabout
howgreathisvacationwould
be.
No
more
traffic,
bosses, fellow employees, or
monotonous work for two
weeksofblissbytheocean.
Butfornowhehadto
focus.
Stock Trader was
casually looking through
some option chains that
baffledhim.
He noticed for the
firsttimehowallthevolume,
open interest, and action
started with the nearest date
at-the-money options in both
CallsandPuts,andthefarther
away and out-of-the-money
he looked, the more chaotic
theybecame.
When he looked up
option chains and compared
optionswithstrikepricesthat
were$90ormoreout-of-themoney, the options all had
aboutthesamepremiumeven
though they had different
strike prices and the same
month of expiration. He
figured the chances that they
would all expire worthless
probably played a big role in
the price not being an issue.
They were just random bets
with close to zero odds of
everhavinganyrealintrinsic
value.
Hewasamazedtosee
thousands of open interest
contracts in strikes $200 out-
of-the-money
in
the
upcoming month, no doubt
bought by mega bulls long
agothatwerenowtrappedin
purgatory with no way of
getting out. Two cents bid
with 600 contracts of open
interest was like trying to
squeeze a camel through the
eyeofaneedlewithonly100
contractsadayinvolume.
It was interesting to
see that options deep out-of-
the-money lost all relation to
Delta and Theta movements
and became simply priced
based on demand from
gamblers.Appleoptionsdeep
out-of-the-money
more
resembled penny stocks for
their lack of volume and
randomvaluationsbasedona
fewrandombuyersthanstock
optionsofoneoftheworld’s
premiercorporations.
It appeared to Stock
Trader that the at-the-money
front month Calls were like
thebigcitywithspecificlaws
that were enforced and the
farther away you went from
thiscitythemoreyougotinto
the lawless wild west of
gamblersandgunslingers.
You
could
buy
options a month out that had
strikepriceswithin$90ofthe
underlying price and get no
moveinyouroptionfora$50
ormoremoveinthestock.
He wondered what
Optionz had to say about the
weird movements in options
when you do not get what
youexpected.
Bingo, as
Optionzwasonline.
usual
“He must live at his
computer,” thought Stock
Trader.
StockTrader: Whenweleft
off the other day, you were
talking about Butterflies and
Condors being very slow to
react to changes in the
underlyingprice.
Optionz Traderz: That is
true. One of the most
common complaints I hear
from option traders is that
their options did not behave
as they expected. Unlike
stock trading, it is possible
for the underlying price to
move in a direction that is
favorable to an option
positionandstilllosemoney.
Therearealsotimeswhenthe
share price can move against
an option position and result
inaprofit.
StockTrader: Yes, I think I
remember you mentioning
that when you were
explaining Ratio Spreads. It
seemsalittlecounterintuitive
that options sometimes
behave opposite to the way
onemightexpect.
Optionz Traderz: It can be
frustrating,anditmaybeone
of the main reasons that
traders abandon option
trading. However if you
understand the behavioral
problems
of
immature
options, it will not only give
youtheconfidencetostickto
yourprovensystem,butthere
may be times that you can
take advantage of those
behaviors.
StockTrader:I’mnotsureI
understand.Howisitpossible
to predict when an option
won’tbehaveasexpected?
OptionzTraderz: Well,itis
notpossibletopredicthowan
option strategy will behave
under all circumstances, but
there are some general
guidelinesthatcanbeusedto
makeaneducatedguess.
Stock Trader: O.K., I’m
withyousofar.
Optionz Traderz: First, as
youknow,optionshavemuch
less liquidity than stocks.
There are almost always
fewer option contracts traded
than shares of the underlying
stock.Theresultofthelower
liquidity is that the bid/ask
spread is normally much
wideronoptionsthanitison
stocks,evenonthosethatare
heavilytraded.
StockTrader:Ihavelooked
up some option chains and I
havetoadmitIwassurprised
to see that some of the
bid/ask spreads were in
excessof$1.00.
OptionzTraderz:Evenona
heavily traded stock such as
Apple, where the bid/ask
spread on the shares is
sometimes5centsorless,the
spread on at-the-money
options can be 25 cents or
more. Generally, the further
out you go in the expiration
date of an option, the greater
the spread. Also, depending
on the particular stock, some
expirationdatesmaybemore
popular than others. For
example, there may be high
volumeonoptionsexpiringin
oneyearandthoseexpiringin
one month, but almost no
volume on those expiring in
three months. In that
scenario, it is likely that the
bid/ask spread could be
significant on the threemonth-outoptions.
Stock Trader: You have
mentionedmanytimesthatit
is very important to consider
liquidity
when
trading
options, not only in terms of
volume, but also the amount
of open interest at a specific
strikeprice.
Optionz Traderz: I’m glad
you were paying attention
becauseliquiditycandrivean
option trader insane if it is
ignored.Sonowwecanadda
secondbehavioralproblemto
the mix: option premiums
changemuchslowerthanthe
underlyingshareprice.
Stock Trader: O.K. That I
understand, thanks to your
explanationofDelta.IfIbuy
a Call option with a Delta of
0.5, the premium should
initially change about half as
fastastheunderlyingprice.
Optionz Traderz: Correct.
So here is where a lot of
option
traders
lose
confidence. When you buy a
stock
and
the
price
immediately goes up, the
tradewillusuallyshowupas
an unrealized gain. Many
discount brokers also offer
very low cost commissions
on stock trades, and some
also offer free stock trades if
certain conditions are met. A
stock trade involving a very
low commission might only
need to experience a price
increase of a few pennies to
showaprofit.
With options, most brokers
charge higher commissions,
and there are often fees that
add to those amounts. The
result is that every option
trade will initially appear as
anunrealizedloss,firstdueto
thewiderbid/askspread,and
second due to the higher
commission. Because the
option premium changes
slower than the underlying
share price, it takes much
more of a move to offset the
initialloss.
Stock Trader: So every
option trade will look like a
loss when I first open it, and
that loss will take longer to
erasethanitwouldonastock
trade?
Optionz Traderz: Exactly,
and as we have discussed in
the past, changes in the
underlying share price can
affect Implied Volatility,
which can cause unexpected
changes in option premiums.
This is especially true of
immature options; those with
thelongestamountoftimeto
expirationaregenerallymore
vulnerable to changes in
volatility than those nearing
expirationday.
ACalloptionmaynotgainas
much value as expected,
when the underlying price
rises, if the market perceives
theincreaseinpriceinaway
that causes fear of falling
prices to diminish. The
decreaseinImpliedVolatility
is reflected in a smaller
increaseinthevalueofaCall
due to the effect of Vega.
Likewise, a Call may lose
lessvaluethananticipatedifa
decrease in the underlying
price creates fear and
uncertaintyfortraders.
The opposite is true of Put
options, which normally gain
value more quickly in a
downtrend while also losing
value more quickly in an
uptrend.
Stock Trader: So Puts are
more sensitive to changes in
the underlying price than
Calls?
Optionz Traderz: As a
general rule they are more
sensitive, but there are times
when volatility does not
match the direction of the
pricemovement.Itispossible
for the underlying price to
rise while Implied Volatility
is increasing and decrease
when volatility is falling. I
believe one of the easiest
waystounderstandthisisby
studying options on an
inverse ETF, such as a bear
ETFthatmimicstheopposite
behavior of the general
market. When the market
makes a strong downturn,
Implied
Volatility
will
usually increase, but a bear
ETF will see its share price
rise in spite of the Increased
Volatility. The effect of
volatility spreads across the
market like a virus, infecting
bull ETFs and bear ETFs
alike. The result is that the
options on bear ETFs may
behave the opposite of what
one might expect, as far as
changes in general market
volatility.
Stock Trader: I think I see
where you are going now. A
stock or ETF that tends to
move in the opposite
direction as the rest of the
market might have Call
options that are more
sensitivethanPuts.
OptionzTraderz:Theeffect
isnotoftenahugeone,butit
issomethingtokeepinmind.
Inverse ETFs, precious
metals,andcommoditiessuch
as oil can all have price
movementsthatcontradictthe
rest of the market, and that
can have an effect of the
behavior of the associated
options.
Stock
Trader:
You
mentioned that the effect of
volatility is greatest on
immature options, so I’m
assumingthatitdisappearsas
the
option
approaches
expiration.
Optionz Traderz: Correct
again. As options mature,
they begin to act their age.
When they reach the final
daysleadinguptoexpiration,
there are few surprises when
it comes to changes in
premiums. Also, volume
tends to increase in the final
daysoftrading,especiallyon
expiration day itself, as
traders roll out, exercise, or
close their positions. The
increased
liquidity
can
sometimesnarrowthebid/ask
spread,whichalsomakesthe
option premiums more
predictable.
StockTrader:Sothatwould
explain
the
increasing
popularityofweeklyoptions.
Optionz Traderz: That and
the increased rate of time
decay makes selling weekly
options attractive. At the
same time, the lower
premiums on weekly options
make them desirable for
buyerswhoareattemptingto
limittheirlossexposure.The
combination of liquidity and
the relatively small effect of
changesinvolatilitycausethe
premiums of weekly options
tobefairlypredictable.
Stock Trader: Any other
thoughts?
Optionz Traderz: Another
behavior problem of all
options,
especially
the
immature ones, is that they
liketosleeplate.
StockTrader: LOL,I’mnot
sureIunderstand.
Optionz Traderz: I’m sure
you have noticed that stocks
tendtohaveveryhightrading
volume right after the
opening bell. Normally
volume drops off as the
morning progresses and a
final increase in volume then
precedes the closing bell.
Many stocks are also traded
in the pre-market hours as
well as after-market. Not so
withoptions;theyneverstart
earlyorstaylate.
But even with shorter hours
than stocks, options aren’t
content with a trading day
that is confined to regular
markethours,sotheytendto
sleep late. Most options have
very little trading volume at
the open, and the effect is
usually more pronounced
with those that have longer
times to expiration. When a
new chain of options is first
introduced, it can sometimes
be an hour or more after the
open before a single trade
occurs. The bid/ask spread,
even on heavily traded
options, can be significant in
the first hour of each day’s
trading.
Stock Trader: I would not
have thought of that, but I
believe you are correct. If an
option
chain
normally
experiences
its
highest
volumeataparticulartimeof
the trading day, opening or
closing a trade at that time
could help ensure the
minimumamountoflossdue
tothebid/askspread.
Optionz Traderz: Yes, it’s
just another way of
decreasing liquidity risk. As
we
already
discussed,
immature options tend to
have lower liquidity than
thosenearertoexpiration.
Stock Trader: O.K., if I
understand what you have
saidsofar.Immatureoptions
don’t always behave as
expected. Trading volume is
usuallylowerwhenanoption
has a lot of time remaining
untilexpiration,whichcauses
the bid/ask spread to widen.
In addition, changes in
volatilitycancauseimmature
Puts to be more sensitive to
movesintheunderlyingprice
thanCalls.
Optionz Traderz: You’ve
got it. So let’s move on to
immaturecombinations.
Stock Trader: As
StraddlesandStrangles?
in
Optionz Traderz: Exactly.
In a Straddle or Strangle,
volatility tends to lower the
sensitivity of the Call and
increasethesensitivityofthe
Put. The result is that a
Straddle may not behave as
expected in an uptrend. The
lower
volatility
may
sometimes decrease the time
valueofbothoptionsenough
to offset the increase in
intrinsic value gained by the
Call.Theoppositeistrueina
downtrend, where volatility
may cause a Straddle to
increase in value faster than
anticipated.
Stock Trader: That makes
sense. So a Long Straddle is
actually a slightly bearish
strategy and a Short Straddle
isalittlebitbullish?
Optionz Traderz: Straddles
and Strangles are often
described
as
neutral
strategies, but when the
options are immature their
behavior gives them a bias
that makes them perform
betterincertainmarketsthan
inothers.
Stock Trader: What about
combinations of Calls and
Puts in Synthetic Stock
positions?Dotheyexperience
thesameeffects?
Optionz Traderz: Yes and
no. They are exposed to the
same forces as Straddles and
Strangles, but the effect on
one option is offset by the
effect on the other. For
example,inaSyntheticLong
Stock position created with a
Long Call and Short Put, the
Call’s performance will tend
to lag in an uptrend, but the
decrease in volatility will
increase the performance of
the Short Put; they cancel
each other out. Synthetic
Stockpositionsareessentially
immunetoallofthebehavior
problems of options, except
liquidity.
Stock Trader: So with
Synthetic Stock, I am selling
Theta to buy Theta, selling
exposuretoVegaandbuying
exposuretoVega,andselling
negative Delta and buying
positiveDelta.
OptionzTraderz:I’venever
seenitwordedquitethatway,
but you are correct.
Everythingcancelsoutexcept
that selling negative Delta is
equivalent to buying positive
Delta, so you are essentially
buying
Delta,
twice.
Disregarding the loss on the
bid/ask spread, the position
shouldbehavethesameasthe
stock, dollar for dollar, no
matter how much time
remainsuntilexpiration.
Stock Trader: Any other
behavior problems I should
knowabout?
Optionz Traderz: Let’s
see… We talked about
Spreads. Spreads are not
entirely immune to changes
in volatility, but the effect is
reduced considerably. In a
Vertical Bull Call Spread, if
theunderlyingpricerises,any
decreaseinImpliedVolatility
thatloweredthetimevalueof
theLongCallwouldalsotend
to decrease the value of the
Short Call. The effect of
volatility is not exactly the
same at two different strike
prices, but it is usually close
enough that it does fall into
the ‘bad behavior’ category.
Byfar,thebiggestbehavioral
problem with immature
Spreads is that they are lazy.
However, as I mentioned a
few days ago, you can use
that behavior to your
advantage, cutting losses
when
trades
move
unfavorably and holding
winners until they mature
enough to show their true
value. I’m sending you a
charttoshowwhatImean.
Stock Trader: LOL, thanks
for sending this. I can really
see what you are implying
when you say immature
optionsarelazy.TheVertical
Spreadusingmonthlyoptions
was very slow to react, even
when the share price was up
and down as much as $25.
The weekly options were
muchfasteratpickingupthe
fullvalueoftheSpread.
Optionz Traderz: The
weekly Spread can also lose
valuemuchfasterifthetrend
goes against you, so those
options aren’t necessarily a
better choice. It all comes
down to your trading style
andpersonality.Sometraders
would prefer holding the
monthly Spread for an extra
two weeks, given that the
Long Calls ended the week
more than $25 deep in-themoney. Other traders would
rather take on the additional
risk of the weekly Spread
quickly becoming worthless
in a downtrend, in return for
the faster price discovery in
anuptrend.
Stock Trader: So it’s ‘slow
and steady,’ or ‘fast and
furious.’
OptionzTraderz:That’sone
way of looking at it. The
effect becomes even more
evident
when
multiple
Spreads are used, such as
withButterfliesorCondors.
StockTrader:SoaButterfly
Spread will have an even
slowerpricediscoverythana
singleVerticalSpread?
Optionz Traderz: Normally
that is the case. Unless there
is a very strong trend in one
direction or the other, a
Butterfly
will
usually
experience little change in
value until the week of
expiration. Even then, most
of the change occurs during
the last few days. There are
times when the underlying
pricecanmovetoapointthat
wouldresultinthemaximum
profitforaButterfly,andthat
profit might not fully reveal
itselfuntiltheverylastdayof
thecontracts.
Stock Trader: That seems
reasonable. If I open a Long
Call Butterfly Spread, and
Delta is 0.6 on the lowest
strike, 0.5 on the middle
strike and 0.4 on the highest
strike, small changes in the
underlying price will have
little effect. The two Long
Callswouldgain60centsand
40 cents respectively, for
every dollar increase in the
stockprice,andthetwoShort
Calls would lose 50 cents
each.
Optionz
Traderz:
A
Butterfly can be nearly Delta
neutral when it is initially
opened. The profit from a
Butterflyisaresultofslightly
fastertimedecayontheShort
optionscomparedtothelong
ones. Because the difference
in Theta is usually quite
small,ittakesalotoftimefor
aButterflytorealizeaprofit.
Even when a Butterfly trade
works perfectly, if onemonth-outoptionsareused,it
cantakeaboutthreeweeksto
seethefirsthalfoftheprofit.
The final half of the time
decay usually occurs in the
finalsevendays.
Stock Trader: I see, so the
same should also be true of
Reverse Butterflies and
Condors; if the trade is in a
position to experience its
maximumlossthatlossmight
notappearuntilthefinaldays
oftrading.
Optionz Traderz: Exactly.
That makes it very easy to
trim losses. However, as we
discussed earlier, Butterflies
and Condors have an
additional
behavioral
problem:theyeattoomuch.
Stock Trader: Now that
analogy I get! With as many
as eight trades required to
openandcloseaButterflyor
Condor, those trades can
really eat up a lot of
commissions.
Optionz Traderz: I think
thataboutcoversmostofthe
unexpected behaviors you
might experience with the
different option strategies.
There are a few additional
problems that can cause all
options to act in ways that
cancatchyouoffguardifyou
aren’t prepared for them,
regardlessofthestrategy.
Stock Trader: O.K., I’m
ready.
OptionzTraderz:Ithinkwe
havetalkedaboutthisbefore,
but it bears repeating.
Dividends can cause options
to perform strangely. Option
premiums are based on the
expected price of the
underlying
stock
at
expiration. If an ex-dividend
date occurs prior to
expiration, those premiums
will have the expected
dividend-induced decline in
thesharepricebaked-in.Puts
become
slightly
more
expensive and Calls a little
cheaper.
Stock Trader: I do
remember you mentioning
ex-dividenddatesinthepast.
Optionz Traderz: Assuming
allothermarketforcesremain
unchanged,thepassingofthe
ex-dividenddatewillresultin
the price of the underlying
shares falling by an amount
which is normally a
percentage of the dividend
itself. However, the premium
on the options expiring after
that date will not usually
changemuch.Forexample,if
you sold a Covered Call and
the stock went ex-dividend,
the share price would likely
declinebuttheCallpremium
probablywouldnot,although
you would be entitled to
receive the dividend when it
becamepayable.
Stock Trader: Got it! Any
otherideas?
Optionz Traderz: I hope
you’re not timing me,
because I am about to
mentiontheHolyGrailagain.
Stock Trader: It doesn’t
surprise me to see Rookie
bringitup,butyou?
Optionz Traderz: I don’t
intend to disappoint you, but
Rookie’s infamous no-loss
trade can be helpful in
understanding the effect of
dividends.
Stock Trader: So we are
backtosellingaCoveredCall
andbuyingaPutatthesame
strikeprice.
Optionz Traderz: Exactly.
The only difference now is
that instead of being
guaranteednottolosemoney
on the stock, you would be
entitled to the dividend. In
theory, the Call should be
‘underpriced’ and the Put
“overpriced’ so that opening
suchatradewouldresultina
guaranteed loss equal to the
expected gain from the
dividend.
StockTrader:Intheory?
Optionz Traderz: I say ‘in
theory’ because option
pricingismoreofanartthan
an exact science. There may
be times when such a trade
could result in a loss that
would be less than the profit
from the dividend, what
might be called an arbitrage
opportunity. However, it has
been my experience that few
stocks have options with
enough liquidity to make
such a trade profitable
enoughtoaccountfortheloss
duetothebid/askspread.
StockTrader:You’llhaveto
tease Rookie with that one
sometime. I’m sure he’d like
tofindoutthattheHolyGrail
actuallyexists.Itjustdoesn’t
workinreallife.
Optionz Traderz: That’s
funny.Butseriously,thetrue
Holy Grail of option trading
is
risk
management.
Understanding how options
behaveandlearninghowthat
behavior can change as
options mature is one of the
keys
to
successfully
managingyourtrades.
Stock Trader: So are there
any
other
behavioral
problemstoconsider?
Optionz Traderz: In the
past,wehavediscussednews
events and their effect on
options.Immatureoptionsare
more likely to be influenced
by changes in volatility than
thosenearingexpiration.
Stock Trader: So the
collapseofvolatilityafterthe
release of an earnings report
would have a greater
influence on longer term
options?
Optionz Traderz: That is
often the case. However it
might depend on how often
that particular company
reported its earnings. If
another report was expected
prior to expiration of a long
term
option,
Implied
Volatility might remain
elevated on that option while
simultaneously evaporating
onaneartermoption.
StockTrader:Ihavealways
found it strange that Implied
Volatility can be different
depending on the amount of
time to expiration, but that
makes sense. If there was
increaseduncertaintyduetoa
future earnings release,
Implied Volatility might be
higher on long term options
thanthosewithshorterterms.
Optionz Traderz: Immature
options also have one
additional behavior issue.
They are at a higher risk of
beingaffectedbyastocksplit
orreversesplit.
StockTrader:Whenastock
splitoccurs,aren’ttheoptions
adjusted to reflect the
change?
Optionz Traderz: Yes, they
are. However, it often takes
time for the adjustment to be
completed. During that time,
options
are
normally
unavailable for trading, and
you could get stuck with a
bad trade if the blackout on
trading happens to coincide
with some unforeseen event
inthemarket.
StockTrader:That’salotto
thinkabout,soI’llletyougo,
in case you want to take
another run on the beach.
Thanksforallthehelpagain.
Optionz
Traderz:
As
always, you’re welcome. I
would go for a run, but my
legs are still tired from
yesterday. I may go for a
swimthough;theweatherthis
weekhasbeenunusuallyhot,
even by Southern California
standards.
StockTrader:Thatisfunny.
I will be in San Diego in a
week on vacation. Too bad
California is such a huge
state. Where do you live, if
youdon’tmindmeasking?
Optionz
Beach.
Traderz:
Long
Stock Trader: Oh, where is
that?
OptionzTraderz: Well, you
can get from San Diego to
Long Beach in two hours
with no traffic. Of course we
have plenty of traffic in
California,LOL.
StockTrader: Really? What
do you say about us meeting
for a few beers while I am
there?
Optionz Traderz: How
about I get a martini or
margarita? I really hate beer.
Yuck!
Stock Trader: O.K., as long
asyouletmetalkoptionsand
trading you can drink
whateveryouwant.
Optionz Traderz:
soundslikeadeal.
That
StockTrader:Oh,anditwill
be my treat for all your
teachingaboutoptions.
Optionz Traderz: Now that
soundslikeagooddeal.
Stock Trader: Have a great
swim,myfriend.
StockTraderwasvery
excited about the prospect of
meeting Optionz face to face
in California. It would be
great to break his normal
monotony of reading books
onthebeachandrelaxingasa
lone wolf for the majority of
the time with some quality
time with his college buddy
mixedin.
So few people really
understoodhimandhisgoals
and he felt like Optionz was
already living his dream.
Maybehecouldbeamentor?
Stock Trader thought
that a man who didn’t like
beer was just odd, and he
personally would never get
caught drinking a martini in
public.
Healsohadthefunny
thought that maybe Optionz
could introduce him to some
lady friends and they could
double date, but how good
could he be at the dating
game while drinking girly
drinks?
This would no doubt
beatriptoremember.
Chapter15
ATRADER’S
CHOICES:
INSURANCE,
STOPLOSSES,
ORRUIN
Stock Trader awoke
staringattheceiling.
What a wonderful
morning for him. No alarm,
no traffic, no work day. He
drifted back into a blissful
sleep.
An hour later he
awoke with the wonderful
feeling that one gets on the
first morning of a long
vacation. He wanted this
feelingtolast.
He had to get going,
though, as his plane left in
three hours. He had to leave
plenty of time to be frisked,
x-rayed, and groped by
security before boarding the
plane,orsohehadheard.
“Whattotake?”
He pulled three new
trading books out of his
bookcase that he was
currently enjoying reading.
All of them were about
options,theworldofCollars,
Married Puts, Spreads,
Synthetics,etc.Hereallywas
beginning to feel more
confident about trading
options with each book he
read and each online chat
withOptionz.
“Clothes, check, belt,
check…”
“Wait, I need some
trading magazines for the
plane; here are some good
ones,” he thought, as he
shovedtheminhisbag.
“I also need beach
stuff,swimmingtrunks.”
“I am scared to take
anything that will not be
allowed on the plane, I think
liquids are pretty much
banned. I guess I will just
havetobuythosewhenIget
there,”hethought.
He
went
to
his
computer and tweeted out on
his2ndfavoritesocialnetwork
site:
On his main social
networking site he posted as
hisstatus:
Stock Trader: I am flying
out to San Diego today,
planning on having a blast
with my friend John. I am
also planning to meet the
legendary trader and teacher,
Optionz Traderz, in person
forthefirsttime.
He was finishing up
his packing when a comment
hit his post a few minutes
later.
Optionz Traderz: I am
lookingforwardtoit.
StockTrader:Metoo.
It was time to be off
totheairport.
The security was not
nearly as bad as he had
dreaded and he was soon on
theplane.
He had a copy of the
day’s financial newspaper
and read on the front page
that the airline company
handling his flight had filed
for bankruptcy that very
morning.
“Wow,” he thought.
“That’sjustmyluck.”
The flight went on
and on. With no computer
andnotevenasmartphoneto
play with, Stock Trader tried
tofocusonhismagazinesand
books, but he really missed
the markets and the
interaction online with other
traders. He truly had a
passion for the markets. He
loved nothing more than
catching that big trend and
lettingitrunandrun;forhim
thatwashappiness.However,
hehadtodealwiththetimes
hewaswrongalso.
With each loss he
would think to himself and
sometimessayoutloud,
“The market giveth
and the market taketh away;
ifImanagemyriskIwilllive
totradeanotherday.”
While
it
didn’t
remove the pain of losses, it
helped refocus his mind on
thenexttrade.
Finally, he could see
the ocean out of his window.
HewasinSanDiegoandthe
planepreparedtoland.
Hefeltalittlewobbly
leavingtheplaneaftersitting
still for so long. A four-hour
flightwasalongtimeforhim
to try to sit and entertain
himself.
Hecarriedoffhisbag
and finally made his way to
the lobby after weaving his
way through an endless
crowdofpeople.
StockTradermadehis
way to the car rental place
and got his wheels, a red
Mustang.
“Nice,”hethought.
With his handy smart
phoneheupdatedhisstatus.
Stock Trader: Mission
accomplished, the eagle has
landed.
He made his way to
the hotel and checked in. He
went to his room and
immediately loved the view:
water for as far as the eye
could see. It was a different
world from the land locked
statehewasusedto.
“Freedom!” he said
outloud.
“Now where do I
begin?ShouldIcallgoodold
John or the legend of
Optionz? Hmm… college
stories or option and trading
talk?”
Asmuchashewanted
to meet his Facebook trading
friendinperson,heknewhis
old college buddy would be
awaiting his call. Sure, he
was married now, but John
was always up for some fun
and Stock Trader really
enjoyed relaxing over a few
beers and reminiscing about
some of the crazy times in
what now seemed like the
distant past. Besides, he
would be here for two whole
weeks,plentyoftimetoshare
college stories and also learn
aboutoptions.
A cold beer sounded
like a nice way to unwind
after that long flight.
Unfortunately, his phone call
toJohnwenttovoicemail.
He looked out of his
hotel window at the paradise
below; the late afternoon
December sun shining over
the
seemingly
endless
beaches, dotted by the
occasional surfer or bodyboarder.
Hechangedoutofhis
winter clothes into some
shorts, unpacked a trading
book and smart phone, and
wasofftothefrontdesk.
After renting a beach
chair and obtaining the
hotel’s Wi-Fi password, he
wassoonsittingwithhisfeet
inthewarmsand,listeningto
thesoundofthewaves.
“This is the life,” he
saidtohimself.
But still, he felt the
needtoconnectwithOptionz.
Hetookouthisphone
and sent Optionz a direct
messagethroughthesite.
Stock Trader: I am in your
neck of the woods; any
thoughts on when we can
meet?
About five minutes
later he received his
response.
Optionz Traderz: How
about a nice Sunday brunch
in Long Beach? I will send
youtheaddressinamessage.
Howaboutnoon?
Stock Trader: That sounds
great.IguessIneedtoadjust
toPacificTimefromCentral,
soitwillbelikemy10a.m.
Optionz Traderz: My real
name is Terry and I will be
wearing all green, money
greentobeexact.
StockTrader:Myoff-screen
name is Jack. I look forward
toit,seeyouthen.
“Wow,veryeccentric.
Allgreen?”hethought.“This
should be very interesting.”
He had pictured them
meeting up to leisurely
discuss options over some
steaks at dinnertime, but
brunchwouldbeO.K.too.It
was probably just as well.
Withhisstomachstillsettoa
different time zone, a heavy
meal might not be such a
good idea. Still, there was
something about meeting a
man for brunch that made
himfeeluneasy.
A while later John
returned Stock Trader’s call,
and they spoke for over an
houraboutlife,goals,andthe
future, catching up on old
timesanddreamingaboutthe
future. After an hour, John
got a business call from an
important client, so they
agreed to pick up their
conversation in person later.
John was free after work on
Tuesday, and that fit nicely
into Stock Trader’s plans.
StockTraderendedupsitting
on the balcony of his room
anddrinkingabeerwithlime
andwatchingthesunsetover
theocean.Itwasagreatfirst
day.
The next morning he
woke up early without the
assistance of an alarm clock.
He felt excited and
invigorated.
“Was it his job that
was sucking the life out of
him?”hewondered.
Then guilt rushed in;
heshouldbethankfultohave
a job in this day and age of
recession.
He checked his GPS
to see that the restaurant was
about two hours away. Soon
he and Optionz would meet;
they would be transformed
into Jack and Terry. It was
like being unplugged from
theMatrix.
The drive was simply
beautiful. Jack, the stock
trader, dreamed of retiring
fromhisjobandmovinghere
into a nice condo by the
beach.Thatwouldbethelife
thatOptionzwaslivingnow.
Hegottothefreeway
exitandfeltthebutterfliesin
his stomach. He was hoping
hecouldhangwithTerrythe
options trader in real life,
talking without the pauses of
thinkingandtyping.
He pulled into the
restaurant parking lot and
there,inreallife,wasparked
the pink Cadillac he had
looked at online for so long.
He got out of his car and
walked beside it – perfect
condition.
But he couldn’t help
thinking, “What man in the
worlddrivesaroundinapink
Cadillac,wearingallgreen?”
Ashewalkedintothe
restaurant he saw a portly
manwearingagreenfootball
jersey and blue jeans waiting
tobeseated.Hisspiritsfell.
“Terry?”hesaidwhile
holdinghishandouttoshake.
“No buddy, my name
isBilly,”heresponded.
“Oops, sorry, I am
waiting for someone,” he
said,embarrassed.
“Can I help you?”
Jackwasaskedbythesmiling
andfriendlyhostess.
“Yes,Iamwaitingon
afriend,”hereplied.
“IsyournameJack?”
“Yes.”
“Rightthisway.”
Thehostessledhimto
a table by the window where
a very attractive lady was
seated.
Jackwasdisappointed
again.
“I guess Optionz
brought his girlfriend to
brunch, and she is also
wearing all green. Good
grief!Henevermentionedhe
was bringing his girlfriend!”
hethought.
He
hid
disappointment
introducedhimself.
his
and
“Hello, I am Jack,
known as Stock Trader
online,” he said, as he held
outhishandtoshake.
“I am Terry, better
known as Optionz Traderz
with two ‘Zs,’” she
responded.
Stock trader Jack had
that strange moment of
vertigo, when a person is so
surprisedtheyfeelasifupis
downanddownisup.Hesat
down at the table unable to
hide his surprised look from
Terry.
“What is wrong? You
looksurprised,”saidTerry.
“I uh, just… uh,
pictured
you
looking
differently,”saidJack.
“What does an option
traderlooklike?”sheasked.
Not
wanting
to
offend,hetriedtochoosehis
wordscarefullyandtactfully,
buthewasnotquickenough.
She looked at him
sternlyandasked.
“What, you don’t
thinkgirlscantradeoptions?”
Jack was stunned and
speechless, but Terry let him
off the hook by breaking out
in laughter. He was relieved
that she was not offended.
Suddenly a bunch of things
made sense: the margaritas,
the pink Cadillac, the pet
tortoise, the endless patience
with other traders; it seemed
obviousinhindsight.
“Itissogreattogetto
meetyouinperson.Ifeellike
you are my option trading
mentor,”Jacksaid.
“I have also enjoyed
ouronlinechats,”Terrysaid.
“I realized on the
driveupherethatIwantedto
be just like you when I grow
up,” Jack said with a playful
grin.
“It is a great life, if
you can handle the heat in
trading and on the beach,”
Terrysaidjokingly.
“Well,Iamnotscared
of the beach, so I guess I
betterjustmanagetheheatin
my trading,” responded Jack
confidently.
“So, how was the
drive from San Diego?”
askedTerry.
“Not
what
I
expected,” answered Jack.
“There was very little traffic,
and the countryside is so
green;ithardlylookslikethe
middleofadesert.”
“Yes, December is a
beautifultimeofyearherein
southern California,” Terry
replied. “And the traffic isn’t
always as bad as its
reputation, especially on a
Sunday morning. That’s why
I suggested meeting for
brunch. Late afternoon
Sunday traffic can be a
nightmare.”
The waitress came
andtooktheirordersandthey
soon drifted off into option
talk,evenfasterthanJackhad
expected, having just met
facetoface.
“I am only able to
trade for a living because I
manage all my positions
carefully, first with the
correct position sizing, then
stop losses, and at times
insurancewhenneeded,”said
Terry.
“Youhavetouchedon
these before. I am all ears,
and this is much easier
without you having to type
each response.” Jack relaxed
in his chair and got
comfortable.
“I never risk my
lifestyle or net worth on any
one trade. A good risk is 1%
to 2% of trading capital on
any given trade, for most
systems. Also, I do not
expose my accounts to more
than 6% of total capital loss
at any one time based on
multiple trades. Of course
marketgaps,liketheoneswe
have seen recently, can take
more than you planned; but
6%isagoodbasispoint.That
iswhyitisimportanttohave
adequatecapitaltotradewith
for a living. If a 2% gain in
total account capital in your
account can pay for your
living expenses, then you are
in business. A $200,000
accountwithamonthlyreturn
of$4,000isdefinitelydoable
with a robust strategy. If you
are risking a total of $2,000
pertrade,youonlyhavetobe
right a few more times than
youarewrongtowinforany
given month. Or if you are
right much bigger than
wrong, you can do very
well,”explainedTerry.
“So if I risked, say,
1% of total capital per trade
inamonth,andhadthreestop
out with losses for a total of
$3,000 and five wins that
made $5,000, because they
were all equal, then I would
havea2%gainthatmonth?”
askedJack.
“Exactly, that is how
you trade risk. Of course, in
real life we would hope the
winners were much bigger
than the losers, just as you
would expect with stocks,
based on your trend trading
style. Trend trading, using
stoplossesortrailingstops,is
very similar to many highprobabilityoptionstrategies.”
“In options you also
have the benefit of using
insurance as opposed to stop
losses. In a Butterfly and
Condor the Long Calls or
‘wings’ are insurance for the
Short ‘body’ of the option
strategy against a wild trend.
In a Married Put or Collar,
theLongPutisinsurancefor
the stock. Investors at times
maybuyPutstoprotectgains
in their holdings which for
whatever reason they do not
want to sell. This alternative
does not exist with stocks;
there you just have to use
stop losses and trailing
stops,”finishedTerry.
“I think I understand
allofthatexcepttheCollar.I
don’t recall you mentioning
that strategy before,” said
Jack.
Terry
quickly
apologized. “I’m sorry if I
left that one out during our
online chats. A Collar is
simply the selling of an out-
of-the-moneyCallinorderto
offsetsomeofthecostofthe
premium of a Married Put. I
personally don’t use Collars
very often because they can
be
simplified
using
synthetics.”
Jack pulled out a
smallnotebookhehadtucked
into his shirt pocket and
began to flip through the
pages.
“I see you’ve been
taking
notes,”
Terry
chuckled,“I’mimpressed.”
“I like to keep a
journalofmytradingideas.I
find it helps me to avoid
repeating mistakes I have
made.” Jack quickly flipped
through a few more pages.
“Here it is; I wrote down the
formulas you gave me for
synthetic option positions.
Let’s see… A Married Put is
the same as a Long Call. If I
add that to a Short Call, it
makesaCollarthesameasa
VerticalBullCallSpread?”
Terrysmiledandthen
replied: “You are correct. I
probably should have talked
about Collars earlier because
they can be useful in
protecting gains on a stock
you already own. The Put
acts as insurance against the
stock price losing value, and
selling the Call helps offset
someorallofthecostofthat
insurance.”
Their brunch arrived.
French toast, pancakes,
bacon, eggs, and hash
browns; it all looked great to
ahungrypairoftraders.
“If you want to trade
options you have to think of
risk first and profits second.
You have to understand all
elementsofriskineachtrade.
TheThetathatwillevaporate
on your Long options, the
directionaltrendriskonyour
Short options, the expiration
date when they will become
worthless, the percentage of
your capital that is at risk in
each option play. With
options there is the risk that
you will have volume dry up
as you win, with your
positionendingupsodeepinthe-money that you might
have to take a big loss to
closeyourwinner.Ifyoujust
wait for it to be exercised at
expiration, then you run the
riskofthetradegoingagainst
you. So an exit strategy
should be planned to avoid
this situation, among many
others,” explained Terry in
hercalm,confidentvoice.
“So I take it that risk
is by far your number one
theme that you think about
before anything else while
planning an option trade?”
askedJack.
“You would be
correct. The question is not
howmuchcanImakeifIam
right, but how much can I
lose if I am wrong? What is
my possible upside and what
is my possible downside? If
my possible upside is small
and my possible downside is
huge, then no trade is
warranted. I want a good
reward/risk scenario to make
it worth my trouble,” she
said.
“That is the same
principle I use for trading
stocks,”Jackadded.
“I do trade options
with the same ideology, but
as you know, there are many
more moving parts and
possible outcomes with
option strategies. An option
trader should carry much
moreofacashpositionthana
stock trader. You can very
easily get 30:1 leverage with
options, but you really only
need1:1leveragewithalarge
account. So you can keep
90%-95% of your capital
safelyincashandfocusyour
attentiononjusttheverybest
trades.Itisverydangerousto
getcarriedawaywithoptions
andhavedollarsignsinyour
eyesandjustgoforwhatyou
think is a can’t miss trade –
which is all fun and games
until you blow up your
account with just one bad
‘can’t miss’ trade that puts
you out of the game,”
cautionedTerry.
“I know what you
mean.Ihavetokeepcatching
myself not fully grasping the
leverage of trading 10
contractsbecauseitmayonly
cost me $3,000. But unlike
stocks where the worst move
may be 7% or 8%, options
can go down 50% in a few
days due to an adverse move
in the underlying. I have to
get used to much smaller
trades and much bigger
percentagemoves,”saidJack.
“I believe options
have a tendency to amplify
emotions as they amplify
leverage; it is more difficult
to trade with Theta ticking
awayeachdayonyourLongs
and violent moves against
yourpositiontakingawaybig
percentages while liquidity is
dryingupandthebidandask
spread is expanding against
you. It can become intense,
andifyouaddtradingtoobig
of a position to the balls you
are already trying to juggle,
you may not be able to think
rationally with all the heat,”
cautionedTerry.
“Ihavebeenwarned,”
Jackassuredher.
“Define your risk
before any trade. What
percentage of your account
can you risk? How many
losses can you handle in a
row?Ifyouareusingoptions
as insurance, place them as a
hedgeatapointthatcontrols
your total risk in your
position to less than 1% or
2%ofyourtotalcapital.You
havetogetyourriskdownto
an amount that eliminates
yourriskofruin,theriskthat
youwilleventuallyblowyour
account up completely by
riskingtoomuchpertrade.It
allstartswithapercentageat
risk then a proper position
size,”shecautionedagain.
“I am familiar with
the risk of ruin; I agree with
you. If you divide your
capital into equal increments
and then risk 1% of your
capitalpertrade,thenafter10
lossesinarowyouaredown
10%;risk10%ofyourcapital
pertradeandafter10straight
lossesyouareruined.Thatis
risk of ruin in a nutshell,”
Jackassuredher.
“Anyone who has
been trading for a while has
had ten straight losses in a
row. Some hedge funds
mismanagetheirrisksobadly
thatallittakesisonebigloss
and they are done,” said
Terry.
“That is sad, but
amazinglytrue,”agreedJack.
Terrycontinued,“Itis
sortoflikethetrafficherein
southern California. Anyone
who has driven here long
enough has been caught in
multipletrafficjams.Anyone
who ignores that eventuality
isriskingtheconsequencesof
beinghorriblylatearrivingat
their destination. A hedge
fund that mismanages risk is
the equivalent of a job
applicant taking the freeway
togettoajobinterview.Any
unforeseen event could cause
him to miss the interview,
and he might never get a
secondchance.”
“Youranalogiesareas
good in person as they are
over the Internet,” Jack
responded.
Withemptyplatesand
Jackthoroughlywarnedabout
the dangers of risk and the
importanceofstoplossesand
insurance, they had finished
their first hour together. Jack
wasfarmorepleasedthanhe
had even imagined with this
face to face meeting. Not
whathewasexpecting,buthe
wasverypleasantlysurprised
with Optionz Traderz turning
outtobethelovely,friendly,
andoutgoingTerry.
Jackhopedthiswould
be the first of many face-tofacemeetingswithTerryover
thenexttwoweeks.
“Could I get a doggie
bag for these strawberries?”
Terryaskedthehostess.
“She is taking a
handfulofstrawberrieshome;
howodd,”thoughtJack.
Seeing the perplexed
look on Jack’s face, Terry
explained: “They’ll make a
nicedinnerformytortoise.”
As they left the
restaurant,heopenedthedoor
for her and then they chatted
for a minute as she got into
herlegendarypinkCadillac.
As she got into her
car,Terryquicklysaid:“Oh,I
almost forgot. I have worked
out the odds for many
differentoptionstrategiesand
Iprintedoutacopyforyou.”
“Thanks,”
Jack
replied, as he leafed through,
scanningthemanytablesand
graphsshehadprepared.“I’m
sure these will be as helpful
astherestofyouradvice.”
As she sat in her
convertible with the top
down, he asked her a
question,
somewhat
nervously.
“What do you say
aboutmetakingyoutodinner
tomorrownight?”
“What are your
intentions for this dinner?”
sheaskedcynically.
He paused, then
looked right in her eyes and
said: “I just want to know
more about what my options
reallyare.”
There
was
an
awkwardpause.Jackthought
surely he had missed the
opportunity.
Maybe he was too
nervous.
“Did she think I was
nervous?”
“Maybe I didn’t
appearconfidentenough.”
“MaybeIsoundedtoo
confident.”
He had taken a risk.
Butwastheriskjustified?
Then, with a giggle
and a smile, Terry broke the
silence.“I’dbehappyto.Just
send me a message on
Facebook when you decide
whereyou’dliketogo.”
It was now early
afternoon and Jack was
feeling on top of the world.
He had a date, not with any
ordinary girl, but with his
mentor. He felt they had a
real connection, not just as
traders but as people. During
brunch they had shared not
only option strategies, but
also dreams and goals. It all
seemed to be progressing so
quickly, perhaps due to the
amount of time they had
spent together previously,
chatting online over the past
severalmonths.
Heprogrammedafew
landmarks into his GPS and
was soon cruising the streets
of Los Angeles in his red
Mustang – his idea of a
dreamcar.
Los Angeles was
certainlyadeviationfromthe
dull landscape of his
hometown. He stopped for a
breakattheLaBreaTarPits
and then continued on past
UniversalStudios,theKodak
Theater, and the Hollywood
WalkofFame.
He continued to stop
occasionally to snap photos
on his phone as vacation
souvenirs.
As he drove deeper
into the Hollywood Hills, he
finally found his ultimate
destination, a spot with an
unobstructed view of the
Hollywood Sign. As luck
would have it, some other
tourists had also chosen the
same spot and they gladly
offered to capture a photo of
him on his phone with the
Sign looming in the
background,highonthehills
above. It would make a
perfect profile picture for his
socialnetworkingsites.
It was such a nice
December afternoon, with
peopleoutsideinT-shirtsand
shorts. This really was the
goodlife.
As he programmed
the GPS for the trip back to
hishotel,hismindwentback
to something Terry had said
at brunch. On a $200,000
account, $4,000 of income
permonthwasnotoutofthe
question
when
trading
options.
He
had
never
seriously considered leaving
his hometown before. But
whatwaskeepinghimthere?
Wasithisnine-to-fivejob?If
he could earn more trading
options than he could while
workingfulltime,therereally
was no reason to be tied
down.Hecouldtradeoptions
from anywhere. Besides, his
friend John had offered to
recommend him for a
positionwithhisemployerin
SanDiegoifheeverdecided
to relocate. He had never
taken John up on the offer
because it would have meant
taking a pay cut from his
current position. But what if
he added the income from
optiontradingtothemix?
Hewasquicklyjarred
from his daydream by a
flashing sign on the side of
the freeway. It read
“SIGALERT.”
“Sigalert, what the
heck is that?” he said to
himselfoutloud.
It quickly became
apparent that it meant he
would not be getting back to
hishotelanytimesoon;traffic
had slowed to a crawl, and
the backup extended as far
into the distance as he could
see.
An hour later, the
traffic began to thin out a
little.Inthemeantime,hehad
managed to keep himself
busylookingatthelandscape,
the mansions perched on the
edge of hills as if they were
onstilts,andhomelesspeople
washing the windshields of
carsastheyslowlymadetheir
way down the freeway off
ramps.Somecarswerefullof
girls in bikinis, probably on
theirwayhomefromadayat
thebeach,andothershadskis
strapped to the roof. Things
were certainly different here
thanwhathewasusedto.
Threeandahalfhours
later, he arrived at his hotel.
Terry’s warning about the
late afternoon traffic had
proven to be accurate, just
likeallofherwarningsabout
optiontrading.
The sun was still
warm and there was a gentle
breeze, so he went out onto
the balcony with his phone
and the charts Terry had
given him. They truly told a
story; every strategy had
different risks and different
potential rewards. It was one
thing to talk about a strategy
like a Vertical Spread, but to
see the charts showing the
odds really made it all so
mucheasiertocomprehend.
His curiosity was
nagging him. Did Terry only
accepthisdinnerinvitationto
be polite? Maybe she had
posted
something
on
Facebook that would give
him a clue to her true
feelings.
Heloggedon.
No new messages, no
newposts.
He decided to see if
she was in the Winning
Traders group, as she always
seemedtobe.
Sure enough, there
she was, engaged in a
conversationwithRookie.He
didn’twantmakeitappearas
though he was obsessed with
her, so he sat back and
watchedwithoutinterrupting.
Rookie Trader: I opened a
Vertical Spread thinking it
would be less risky than a
Covered Call, but I lost
$1,000 when it expired; that
was almost half of my
account.
Optionz Traderz: How
manycontractsdidyouuse?
Rookie Trader: I sold 10
Calls and then bought 10
Callstwostrikeshigher.
Optionz Traderz: There’s
your problem; you were
riskingtoomuchcapitalona
singletrade.Sure,itprobably
looked great on paper. You
would have made a hefty
profit if everything expired
worthless.
Rookie
Trader:
But
shouldn’t my broker have
stoppedmefromopeningthe
tradeifitwastoorisky?
Optionz Traderz: That
might be true if you were
using a full-service broker,
where you pay for advice as
to whether your trade is in
line with your goals.
However,whenyoutradeina
self-directed account, it is up
to you to manage your risk.
The broker’s responsibility is
not to guard your account
from loss, only to protect its
own funds from loss due to
therisksyouaretaking.
Rookie Trader: So what
should I have done
differently?Ionlyhaveabout
$1,000 left in my account,
and I don’t want to lose that
too.
OptionzTraderz:Inorderto
profitintheworldofoptions,
youneedtofollowtherules.
Rookie Trader: The rules?
Doyoumeanyourrules?
Optionz Traderz: Yes and
no.Therearerulestotrading
options for income, but I did
not create them; they form a
sort of ‘natural law’ that is
based upon the properties of
the options themselves. Just
astherearerulestolanguage,
there are rules for successful
trading. Some rules are
obvious and some are more
obscure.
For example, you need to
learn words in order to
communicate. However, it is
not enough to simply learn
the vocabulary; there are
rules governing the usage of
every word. Just as society
determines the rules for
sentence
structure
and
grammar,
the
market
determines the rules for
options.
Learning options is a lot like
learningaforeignlanguage;it
is not sufficient to learn the
vocabulary of options. In
ordertosucceedwithoptions,
you need to learn the correct
usage. Still, even after
learning the vocabulary and
proper usage, being able to
writeandunderstandthenew
language on paper does not
guarantee that you will be
successful using it to interact
with others in real time. In
ordertoexcelintheworldof
options, you need to speak
thelanguagefluently.
RookieTrader:Sowhatrule
didn’tIfollowcorrectly?
OptionzTraderz:Iwouldn’t
sayitwasanyonerule;there
are many. I would suggest
that you read through all of
thepreviousthreadsfromthis
groupwhereIhavediscussed
many of the rules with other
traders. You can’t pick and
choosewhichrulestofollow.
Tobesuccessfulasanoption
trader, you need to follow
themall.
Rookie Trader: I will
definitely read through the
previous posts, but what is
the biggest thing you would
sayIdidwrong?Idon’twant
torepeatmymistakeandlose
the remaining $1,000 in my
account.
Optionz Traderz: Well, the
easiestwaytoavoidlosingit
is to stop trading altogether.
$1,000isn’treallyasufficient
amount of capital to trade
optionsanyway.
But if you are intent on
continuingtotrade,youmust
reduce your position size.
You followed one of the
major rules; you used
insurance when you bought
an option to protect yourself
from ruin if your short
position moved against you.
However,
you
ignored
anotherrule;youriskedmore
of your capital than your
account was prepared to
handle. Then you ignored a
third rule when you failed to
eitheruseastoplossorclose
out of the trade when it
movedagainstyou.
Rookie Trader: So I should
onlybetradingfivecontracts
insteadof10?
Optionz Traderz: Actually,
you should be trading less
than that. On the Vertical
Spread you mentioned, even
oneShortCallcombinedwith
one Long Call at a strike $2
higherwouldexposeyoutoa
loss of $200. Even if you
collected $100 in net
premiums when you opened
the trade, you would still
have a possible net loss of
$100; that’s 10% of your
account.
Risking10%ofyouraccount
on one trade is asking for
trouble.Infact,afriendandI
werejustdiscussingthisvery
issue at brunch today. It is
usually a good idea to limit
your risk on any single trade
to 1% to 2% of your total
capital. Unfortunately, your
accounthasbeendrawndown
toalevelthatdoesnotpermit
that, but risking 10% is still
much safer than risking
100%.
RookieTrader:IguessIsee
what you’re saying. If I risk
$100 on each trade, it would
take 10 trades to completely
wipeoutmyaccount.
OptionzTraderz:Exactly.It
could happen, but it is
unlikely you will have ten
losingtradesinarow.Evenif
that does occur, if it’s any
consolation, I lost my entire
accountthefirstyearIbegan
trading options. That’s why I
nowrisknomorethan2%on
asingletrade.
Rookie Trader: So you are
saying that I should not be
risking more than 2% of my
money on one trade. 2% of
$1,000is$20.Itdoesn’tseem
like I’ll ever get rich doing
that.
Optionz Traderz: Probably
not, unless you increase the
sizeofyouraccount,butyou
won’t blow your account up
either.Letmeaskyou,when
you opened your last trade,
could you feel your heart
beating faster as you pressed
the‘trade’button?
Rookie Trader: Actually,
yes.Doesthathappentoyou
too?
Optionz Traderz: No, not
anymore. In fact, that can be
oneofthebestwarningsigns
you will get that you are
breaking the rules. If your
heartstartsracingoryoustart
to sweat, it means you don’t
have faith in your trade or
you feel you are doing
something risky. Let me ask
youthis:Wouldyouhavefelt
the same way pressing the
trade button if the most you
couldhavelostwas$20?
Rookie Trader: Well, of
course not. Twenty dollars is
nobigdeal.
Optionz Traderz: And yet
$20 is 2% of your account.
Now try to think of it this
way: A trader with a
$100,000 account who risks
$2,000 on a single trade
shouldfeelthesamewayyou
do risking $20 –nearly
emotionless. Both trades
would result in a 2%
maximum loss. Don’t let the
dollar gains and losses of
other traders concern you. It
is the percentages that are
important.
Rookie Trader: But if I am
only getting small profits, I
willnevergetanywhere.Why
tradeoptionsatall?
Optionz Traderz: As I said
earlier, I lost everything my
firstyear.ThenIreadbooks,
researched options online,
andtestedsomestrategieson
paper. After starting over
withanaccountaboutthesize
of yours, I was able to grow
my capital over time. As my
account grew, I was able to
gradually
increase
my
positionsize,whichgotmeto
where I am today. But as I
was rebuilding my account
after it collapsed, at no time
did I intentionally break the
rules. When you break the
rules, the market will almost
always find a way to punish
you.
Rookie Trader: So the rule
is2%riskoneachtrade?
OptionzTraderz:1%to2%
per trade is what worked for
me, and I rarely risk more
than 6% on all my trades
combined. But when my
accountwassmall,therewere
times when it was not
possible to meet those
guidelines,soIgotascloseas
I could. Like I mentioned
earlier,10%ofcapitalatrisk
is not ideal, but it is much
betterthan100%.
Rookie Trader: So you’ve
beenwhereIamnow.Iguess
I should have asked for your
advice before I opened the
trade, instead of after. Well,
thanksforallthehelp.I’llbe
searching through your
previous posts to learn the
restoftherules.
Optionz Traderz: You are
welcome.
Seeing
that
the
conversation was over, Jack
logged out of the group. He
planned to send Terry a
message later, after he had
picked out a nice restaurant
where he could take her for
dinner.MaybehisfriendJohn
would have some dining
suggestions; after all, he was
always entertaining clients
withfancymeals.
One part of Terry’s
conversation with Rookie
stuckinJack’smind.Shesaid
shehadbrunchwithafriend.
SheconsideredJacktobeher
friend. He felt good about
that;heconsideredhertobea
friendtoo,inspiteofthefact
that they had only met once
in real life. They seemed to
share so many similar ideas
about trading, as well as life
itself.
Whether
their
friendship would continue
wasunknown,buthethought
theprobabilitywasgood.
This was really
turning out to be a nice
vacation.
Chapter16
YOUR
METHOD,
YOURRULES,
YOUREDGE
Jack opened his eyes.
It was safe to get out of bed
in a relaxed state. He was
safelytuckedawayinahotel
and not about to battle the
traffic for the reward of
workinginhiscubiclecage.
He liked this feeling
and wanted to keep it. How
wouldheaccomplishthis?
His cell phone had a
message from his social
networkingapp.
Optionz Traderz: I had a
greattimeyesterday.Youare
greatcompany.
Jack felt a warm
happiness in his heart which
spread throughout his body.
He was having a flood of
mixed-upemotions.Hismind
wastryingtocombine‘Terry’
that he met yesterday with
‘Optionz Traderz’ from the
WinningTradersgroup.
Hisphonerang.
“Heybuddy,whatyou
are up to tonight?” asked
Johnontheotherend.
“Well, I may be
taking my online buddy to
dinner in Long Beach,”
repliedJack.
“Isheassharpandas
cool as you had imagined?”
Johnquestioned.
“Well…
she
is
amazing,” Jack responded in
astrangevoice.
“She? Your option
buddyisawoman?Isn’tthat
a little odd that she never
mentioned that?” John shot
backverysurprised.
“Not really, I just
assumed too much. I should
have realized it. I was
focusingonoptionstrategies,
not her gender,” Jack said a
littleembarrassed.
“Well,Iguessitreally
doesnotmatter.Atraderisa
trader,
right?”
responded.
John
“The funny thing is, I
do not think the world’s best
dating site could have found
meabettermatch,”Jacksaid.
“Goodgrief,Ibetyou
have little heart symbols in
your eyes. Buddy, you need
tofocusonoptionsstrategies
before you mess that whole
thing up. Your trading group
is not a dating service,” John
counseled.
“You are probably
right. She is probably out of
myleagueanyway.Iwillcall
you back once I make plans
fortonight,”Jackreplied.
As he hung up he
ponderedwhathisnextmove
would be. He went to the
balcony without his usual
early morning energy drink.
He felt invigorated just
thinking of Terry and how
great she was. He flipped
through the option notes that
she had handed him. It was
verythoughtfulofhertotake
the time to prepare them for
him.
It fascinated him to
see these odds on options
being winners or losers. He
was sure there would be a
way to generate cash flow
using these notes. He had to
selloptionswithlittleoddsof
winningandbuyoptionswith
great odds of making money
basedonhiscurrentsystems.
He had to take on little risk
and put the risk on the other
side of the option seller or
buyer. If he was wrong he
hadtogetoutofthetrade;if
hewasrighthehadtogetout
at the most profitable time.
He had to be the casino and
let the other traders be the
gamblers. Things were
startingtomakesense.
Hewasreadytomake
his move. He searched steak
housesonlineinLongBeach.
Stock Trader: How about I
treat you to a steak dinner
tonight?
His heart raced in
anticipation of sending the
message. He no longer felt
like a serious trader going to
dinner with his mentor.
Instead he felt like a teenage
boyaskingagirloutonafirst
date – truly a different
relationshipthantheyhadjust
adayago.
Something occurred
to him as he paused. It was
something Terry had said to
Rookie Trader the previous
day.ShehadaskedRookieif
hisheartstartedbeatingfaster
when he pressed the trade
button. She then advised him
that his racing heart was
warning him that he was
taking on a disproportionate
amount of risk compared to
the faith in his trading
system.
Jack thought back to
his own days as a rookie
trader, back when trading
made his heart race like it
wascurrently.Hehadbeena
risk taker and the adrenaline
rush was poor compensation
for his mounting losses that
nearly wiped out his entire
account.Nowadayshefeltno
emotion when he traded,
otherthanthesatisfactionthat
came from watching his
trading system slowly grow
hisaccountovertime.
Today was different.
Hewastakingarisk,butnot
withhiscapital.Hefeltlikea
rookie trader again, getting
readytopressthetradebutton
forthefirsttime,withoutany
faith in the outcome.
However, unlike trading, he
had nothing to lose. The
worstcasescenariowouldbe
arejectionofhisdinneroffer.
“This is the proper place for
emotions; relationships with
people, not money,” he
thought.
He sent the message.
A few moments later there
wasareply.
Optionz Traderz: Sounds
lovely.
Stock Trader: I will send
youtheaddress.Is7p.m.late
enoughtomisstraffic?
Optionz Traderz: Yes, that
is a great idea. You are a
quick learner in other areas
besidesoptions.
Stock Trader: I am a good
student.
Optionz Traderz: I will see
youthen.
The weather was a
little cooler than it had been
the previous day, but it was
still sunny. The cool
temperatures and lack of
lifeguards did not seem to
keep people out of the water
though. As he looked out
over the beach from his
balcony, he noticed a group
of boys with boogie boards
attemptingtoridethewaves.
The three appeared to
bebrothersanditlookedlike
they were having fun – well,
two of them, anyway. The
youngest looked as if he was
trying to catch every wave
that washed in. Most of the
time, the waves were too
smallandnomatterhowfast
he paddled, he got nowhere.
Afterafewminuteshethrew
the board onto the sand and
stomped up the beach to the
blanket where his parents sat
watching.
The middle brother
was having better luck; he
was more selective in the
waves he chose to ride. He
stood with his back to the
ocean, looking over his right
shoulder at the waves
approachingfrombehind.He
ignored the waves that were
too small, but when a bigger
one came he would jump at
the chance. A few times he
managedtocatchagoodone
andrideitasfarashecould,
but other times the wave
would crash over his head,
sending the boogie board
flying as far as the tether on
hisarmwouldallowittogo.
The oldest brother
appeared to be the most
experienced. He also ignored
the small waves, but he also
let some of the bigger ones
passbyhimtoo.Jackwasno
expert,butfromwhathesaw,
the key to boogie boarding
lookedasifitwascatchinga
wave at the precise moment
whenitbegantobreak.Itwas
interesting to watch, and a
fewtimestheoldestbrother's
strategy paid off, taking him
50 yards or more. Once, he
caughtsuchagoodwavethat
itpropelledhimallthewayto
shore. Other times his timing
waswrong,butratherthanlet
the wave crash over him, he
simply stood up and let it
harmlesslypasshimby.
Maybe it was all of
the analogies that Terry had
shared with him, but Jack
began to think of boogie
boarding in terms of option
trading.Shetrulywashaving
aneffectonhismind.
The youngest brother
was like an inexperienced
optiontrader,takingashotat
riding every wave he saw,
regardless of the probability
oftheoutcome.Asmanynew
option traders and stock
traders for that matter soon
realize, attempting to trade
without regard for the
probability of the outcome
can quickly lead to
frustration.
The middle brother
had an edge. He avoided the
frustration that caused his
littlebrothertoquitbytiming
his entry, just as an option
trader
increases
the
probability of success by
using a strategy with a high
likelihood of profiting under
the current conditions of the
market. He didn’t win all of
the time, but he did well
enough that the few times he
wipedoutwerenotenoughto
takeawayhisenthusiasmand
energy.
The oldest brother
was like an experienced
option trader; he timed both
his entry and exit. When he
realizedhehadmiscalculated
the probability of success of
any single wave, he admitted
his error and got out early.
Other times, when it was
clear that his analysis was
correct, he rode the wave
untilexpiration.
Unfortunately,
a
patrolofficeronanall-terrain
vehicle put an end to the
boogie boarding as he
summoned them out of the
water and proceeded to
instruct the family that
swimming was not permitted
when lifeguards were not on
duty.Ofcourse,Jackcouldn’t
heartheconversation,butthe
body language made it fairly
easytodecipher.
Jack returned to his
room and relaxed for a few
hours, all the while thinking
about options and his
upcoming dinner with Terry.
He was on vacation, his
trading accounts safely
protected in cash positions,
andyethewasunabletostop
thinking about options. “Is it
options that have taken over
my mind,” he thought, “or is
itTerry?”
Laterintheafternoon,
after a quick call to John to
tell him about his plans for
that
night,
he
went
downstairs. Jack started up
his Mustang. He loved the
way it sounded and handled
on the road. He had spent a
casual day looking through
thenotesthatTerryhadgiven
him. He anticipated a very
thought-provokingevening.
He pulled up to the
restaurant a few minutes
earlierthan7p.m.Heparked
rightnexttotheCadillac.He
walked confidently into the
restaurant with his notes in
hand. Terry, dressed in all
pink, waved him over to her
table.Ashesatdownshehad
aglassofwineinfrontofher
and had managed to find a
pink outfit – a pink blouse
andapinkskirt.Surprisingly,
shelookedsharpandelegant.
She seemed to be even more
attractive
than
he
remembered from the day
before.
“I guess your favorite
colorispink?”Jacksaidashe
smiled.
“Howdidyouguess?”
Terryshotbackwithagrin.
“Even your wine is
pink,”Jacksaid.
“Well,Iamagirl,you
know,”Terryrespondedwith
aplayfullook.
“Well, my favorite
color was the one you wore
yesterday, green, money
greentobeexact,”Jacksaid.
“I couldn’t care less
about money itself. It is only
atooltogetmewhatIreally
want: freedom, time, and
morechoices,”Terrysaid.
“I agree. How is it
you are able to make
consistent
returns
with
options?”Jackinquired.
The
approachedthetable.
waiter
“I would like a light
beer with lime,” Jack
requested.
“Well, I have specific
rules that I follow that I
believegivemeanedgeover
other traders. I manage my
risk on every trade no matter
howconfidentIamthatIwill
be right. I always want the
odds in my favor and the
possible reward to be worth
therisk,”Terryexplained.
“Would you give me
anexample?”Jackasked.
She whipped out her
computertabletandpulledup
thechartforApple.
Charts
courtesy
of
FreeStockCharts.com
“For
example,
currently Apple is trading at
$405 a share, its 200-day
movingaverageisat$368.In
11 of the past 12 months the
200-day moving average has
been support for this market
leader. 50% of the time the
50-daywillholdassupport.I
cansell1contractfora$270
January Put for $200, the
bid/askspreadisonly3cents
andthereare25,000contracts
currently open to bolster
liquidity.
Youcanalsoseehow
the 200-day is sloping
upwards due to the overall
long term uptrend in this
stock, so the odds are also if
the200-dayisbreachedinthe
nextfewweeksthenitwillbe
much higher than my Put
strike price. The Put buyer is
bettingthatthismarketleader
will lose its support line in
thenext30days.Iambetting
that even if it does it will be
higher when it happens and
the Put will still expire
worthless. That is the key to
sellingPutsinanuptrending
stock, even when it retraces
to the 200-day, it is much
higher than a few weeks ago
when the Put was sold. The
Delta of -.12 reflects exactly
the odds of the buyer being
right. It is a bad bet for the
buyeragoodbetforme,and
agreatwaytopaymyutility
bills.
Nowhereisthefunny
part. I have almost no stress
in this trade because I am
bullishonAppleandwantto
ownitatthe200-daymoving
average. If it goes a few
dollars in-the-money I will
allow it to be put on me. Of
course, I will buy back the
PutifIstartbeingdownmore
than 1% of my account
equity,” Terry explained
beforesippingherwine.
“I think you have
talked about this before, sell
Puts on the hottest up
trending
stocks,
under
supportlevels,”Jackreplied.
“Yes, but only when
theleadersareholdingupfar
abovetheir50-dayandsafely
inanuptrend.Also,onlyone
month out at a time
maximum; be stingy with
giving option buyers enough
time to be right,” Terry
explained as the waiter
approached.
Terryorderedthefilet
mignon and Jack ordered the
porterhouse. Then they got
backtobusiness.
“Puts can generate
some good steady income
from market leaders until
they are no longer leaders;
then you buy Puts,” Terry
said as she pulled up a new
chart.
Charts
courtesy
of
FreeStockCharts.com
“ThischartofNetFlix
really shows how quickly a
stock can crater with the
wrong news. As you can see
though from the chart, I had
time to get out from where I
soldthePutinJuly,whenthe
stock was healthy, until the
breach of the 200-day in
August. While I lost on this
trade, I won for a long time
beforeitcollapsed,sellingmy
Puts over and over again at
the 200-day for premiums.
Beforethecollapseitstarting
feeling like the Delta should
have been zero on the Puts
for this monster stock. I also
felt confident buying Call
options as the price bounced
off or regained and went
through the 50-day moving
averageoverandoverrisking
the Call premium to make a
5%moveinprice.Thatwasa
great system until the
collapse. Even then, I only
lost my Call premium, while
investors trading the stock
itself lost their shirts and
pantstoo.Itispossibletobuy
Putsonatopstockthatloses
the50-daymultipletimesand
cover at the 200-day.” Terry
grinned as she took the last
sipfromherwineglass.
The beer that Jack
ordered sat untouched as he
was completely absorbed
with everything Terry said.
Hismindwonderedbackand
forth between options and
howtrulyamazingTerrywas.
“Ithinkonethingthat
reallyhelpsmewininoption
trading is the fact that I only
watch five of the very best
stocks and a few leveraged
ETFs. I try to become an
expert in support and
resistance levels and how
their options trade based on
market volatility. I make
trades based on historical
odds,notguessesorhopesor
gambles.
If
something
already traded a certain way
thelasttentimes,Ibetthatit
will trade that way again.
SometimesIthinkaboutwhat
the dumbest thing an option
trader could do right now
would be. Then I do the
opposite,” Terry said, then
laughedoutloud.
“So you are truly an
option trader that trades
option probabilities? You are
not really a trend trader,
swing trader, day trader, or
positiontrader?”Jackasked.
“You are correct. I
would say I am a probability
trader.ItradewhatIthinkthe
odds are in favor of. I will
trade anything that I think
will be profitable with
options. I attempt to trade
what the market is saying to
me, not what I think will
happen. I do not predict; I
figure probabilities,” Terry
explained with a look of
authority.
“Areyouachameleon
trader? Selling options above
support and resistance when
you see a range bound
market?
Selling
Short
Straddles in quiet markets
while buying Strangles when
you see things possibly
getting very volatile? Buying
Calls on hot stocks at key
supports and selling Puts on
momentum stocks at the last
place of support? Using
Synthetic Longs or Shorts to
take positions you are very
confident in with little to no
capitaloutlay?Andyoudoall
thiswhilekeepingyourmind
and emotions clear, studying
charts,andmakingcalculated
controlled risks on each
trade? Is that all there is to
it?”Jackaskedexasperated.
“Yes, piece of cake,
huh?
“I take my trading
very seriously. Tortoise’s
have to eat, you know!”
giggledTerry.
“Options are far more
complex than my simple
trendfollowingsystems.Iam
playingcheckersandyouare
playing 3D chess. I need a
trend.Youjustneedtheodds
in your favor over and over
again. I am looking for the
right set up and entry. You
areaskingwhatthemarketis
tellingyoutodoatanygiven
moment.Thisisfascinating,”
Jacksaid.
Their steaks arrived
justastheyhadordered.Jack
finallyrealizedhehadabeer
andthattherewerecoldrolls
withbutteronthetable.
Suddenly,
Terrybecame
serious for a
moment, her
face
stern.
She began to
speak in a
very serious
tone as if to
warn and at
thesametime
motivateJack
on
his
journey with
options.
“The markets
must
be
studied just
likeanyother
profession or
endeavor.
That is why
very
few
people will
ever attain
the highest
success
in
trading, just
like very few
people ever
attain
the
highest ranks
in any other
field, be it
medicine,
sports, music,
science,
or
any
other.
Emotions
shouldalways
be restrained
and should
play no part
in
trading
decisions.
Rather,
trading
decisions
should
be
based
on
great
opportunities
as opposed to
hopeful
situationsand
dreams. To
take
advantage of
those
situations,
successful
traders need
to rely on
solid trading
rules instead
of emotions.
Stocks
act
like human
beings; they
go through
the
same
stages
and
phases
as
people
do,
including
infancy,
growth,
maturity, and
decline.”
She
continued,
“The key in
trading is to
be able to
recognize
which stage
the stock and
the market is
inandtotake
advantage of
that
opportunity.
Getting
a
deep
understanding
of
the
psychology of
themarketsis
very
important.
Thekeyplace
to be for the
best profits is
in the growth
stage because
people make
prices
and
behind prices
are profits,
profits
therefore are
shaped
by
people. The
actions
of
people and
profits
ultimately
drive stock
prices either
upordown.”
“I think I understand.
It is not magic. It is work,
yearsofdedicationandfocus,
then profits,” Jack said with
understanding
and
seriousness.
“It is a job like any
other, except the reward is
freedomandtime,alongwith
your own dress code and no
commute. Of course, you
havetomanageanyfearsyou
have of not getting a steady
paycheck and of having to
handle your finances during
those months when you do
not make any profits or even
lose,”Terrycautioned.
“No doubt, I have
been warned,” Jack assured
her.
“The
biggest
difference between stock
trading and option trading is
thatoptionsallowyouamuch
wider variety of methods.
With stocks, you can only
profitbybuyingandsellingat
ahigherprice.Thereareonly
two trading methods with
stocks:buyandsellhigher,or
short and buy to cover
lower,”explainedTerry.
“That is true,” Jack
replied.“Youhaveshownme
literally dozens of option
strategies, but there are only
twowaystotradestocks.”
Terry’s tone turned a
little sarcastic as she replied,
“Actually there is a third
‘method’ for profiting from
stocks: buy and hold. In
reality it is not trading,
though, because the stocks
are only bought, not sold.”
Then she continued in her
normal tone. “But even with
three trading methods, stocks
are much more limiting than
options. I think the single
greatest characteristic of
options is that they are so
flexible. When you trade
options, the number of
trading methods is virtually
limitless.”
Jack
nodded
in
agreementashetookasipof
hisbeer.Thenheinquired,“I
likeknowingthatthereareso
many
different
option
strategies, but doesn’t that
alsocauseyousomestress?I
mean,onceyouopenatrade,
don’t you start to second
guess whether that was the
bestmethod,orwhetherthere
was another one that might
haveworkedbetter?”
Terry paused for a
momentasshefinishedabite
of her steak, then responded
byasking,“Doyouhaveany
regrets about ordering the
porterhouse?”
Jack
quickly
answered,“No,thisisoneof
the best steaks I have ever
tasted;muchbetterthanwhat
I am used to getting back
East.How’syours?”
“Very tasty. I really
likethecombinationofspices
andthetextureisperfect.But
seeinghowmuchyouseemto
be enjoying your porterhouse
doesn’t make me second
guess my choice of filet
mignon,” she said with a
smile.
Jack laughed a little.
“I didn’t realize you were
using our entrées as an
analogytooptions.SoIguess
what you’re getting at is that
there are a lot of different
strategies for trading options,
butthedifferencesaresubtle,
like a Straddle being almost
thesameasaStrangle.”
“That’s what I like
about you, you always seem
to know what I am saying
without me actually saying
the words,” she said with an
almost affectionate stare.
“Whether I’m eating a
porterhouse,ahamburgerand
fries, or filet mignon and
bakedpotato,I’mstillgetting
the same basic meal. When I
tradeoptions,allIneedtodo
is choose the strategy that
meetsmyindividualtaste.”
“And return it for a
partial refund if it doesn’t
meetyourexpectations,”Jack
added.
“Exactly.Thestrategy
youuseisdeterminedbyyour
trading method and your
rules.Solet’ssayyouwanted
to trade options strictly as a
trend trader. Such a method
would require only that you
pick the strategy that would
be most likely to produce a
profit if your trend indicator
was correct. You can use the
charts I gave you as a guide.
If you were bullish, you
would have your choice of a
Long Call, or a Naked Put,
Covered Call, Strangle,
Straddle,ReverseButterflyor
Condor, to name a few. The
decision of which one to use
would likely be based on the
position you were predicting
the stock to reach during the
term of the contracts. A
prediction of a move to half
ofastandarddeviationwould
have associated strategies
with different probable
outcomes than those related
to a move of two standard
deviations.”
Jack finished the last
few bites of his steak. “The
chartsyougavemewerevery
helpful in visualizing the
different strategies. So if my
method is to spot trends and
use options to profit from
those trends, all I need to do
is choose the strategy which
matches both my prediction
and my personal tastes based
onriskandreward.”
The waiter returned
with a dessert menu. Jack
wasn’t hungry after finishing
off a 20-ounce steak, but he
didn’t want Terry to feel
uncomfortable if she wanted
desert.Helookedthroughthe
menu. “The crème brûlée
looksgood,maybewithacup
of coffee,” he thought to
himself. “I’ll have the crème
brûlée and a regular coffee,”
said Terry. “Same for me”,
added Jack. As the waiter
took the empty dinner plates
from their table, Terry
continuedtalkingoptions.
“There are a few
differentmethodsIhaveused
when I trade options. Like
yousaid,itispossibletouse
technical indicators to look
for trends and then use the
best strategy to fit the trend.
Matchingthestrategytowhat
the indicators are telling you
willgiveyouanedge.Ihave
traded that way in the past;
and I still use that method
from time to time on the
handful of stocks and ETFs
thatIfollow.”
“So are there other
methods?”askedJack.
“I sometimes place
trades on all of the stocks on
my watch list, regardless of
whethermytechnicalanalysis
ispointingtowardsatrend.It
is a somewhat different
method in that it involves
matching an option strategy
to every individual stock,”
Terryreplied.
“Sothatwouldbethe
‘chameleon’ method,” Jack
chuckled. “A range bound
strategyonyourrange-bound
stock, a Strangle on your
stock that was approaching
earnings,etcetera,etcetera.”
“That’s funny. ‘The
Chameleon Method’ – that
might be a good name for a
book on option trading, if I
ever decide to write one.
There is also another method
IusewhenIeitherdon’tfeel
like studying the markets or
whenIdon’thavethetime.I
sometimes
use
neutral
strategies. It’s not like I am
livingunderarock,butthere
are times when I have better
things to do than watch the
financial news networks or
read the newspapers. There
aremanystrategiestochoose
from,butoneofmyfavorites
is the Ratio Spread. I often
openaRatioBullCallSpread
andBearPutSpread,asclose
asIcangettoneteven.Then
I just manage the trade as it
evolves over time. The only
way it can lose is if the
underlying stock moves by
more than one standard
deviation,soit’safairlysolid
trade despite the lack of
researchthatgoesintoit.”
“Is there a name for
that trade?” Jack inquired. “I
don’t recall you mentioning
thatonebefore.”
Terry
quickly
answered with a grin, “It
doesn’thaveanofficialname
thatIknowof,soIliketocall
it a Bu-Terry-Fly. I already
calculatedtheprobabilitieson
it.” She pulled up a diagram
on her tablet and passed it
acrossthetabletoJack.
“Now I see what you meant
when you said option
strategies with names aren’t
necessarilysuperiortothoseI
can create myself,” Jack said
withadmiration.
“I’m glad you like it.
There are probably hundreds
of possible strategies that do
nothavenames.Butjustlike
anystrategy,thisoneneedsto
bemanagediftheunderlying
beginstoapproachoneofthe
break even points,” added
Terry. She pulled up another
chart on her tablet, then
continued, “Like all Spreads,
thisoneisverystableaslong
as the stock price remains
between the break even
points.Itonlybeginstoshow
a profit when it is close to
maturity. My edge on this
trade comes not from the
entry,buttheexit.Ifthetrade
startstogoagainstme,Ijust
exititearly.”
“So if my method
involves neutral strategies, I
willnotseemuchprofituntil
the trades are very close to
expiration, but I will also be
able to exit the trades with
small losses, or possibly
smallgains,ifIgetoutwhile
the underlying is in-between
thebreakevenpoints.Thisis
justamazing,”Jacksaid,with
even more admiration in his
voice.
They
continued
talking, even as the waiter
brought their desserts to the
table,neverlookingupexcept
tosay“Thankyou.”
“So there is a trend
trading option method in
which you study a stock and
onlyopenoptionswhenyour
technical analysis shows an
upcoming trend is likely.
Thereisachameleonmethod,
in which you open positions
on some or all of the stocks
onyourwatchlist,regardless
of any trend, but match the
option strategies to the
market conditions for each
individual stock. And then
thereistheneutralmethod,in
which you don’t make a
prediction about the stock
price, but open option
positionswithawiderangeof
profitability, and then simply
cut your losses in the rare
event that it becomes
necessary?” asked Jack as he
lookedatTerryintently.
“Thereareafewmore
methodsthatIuse,”answered
Terry as she poured cream
andsweetenerintohercoffee,
“but not as often as the ones
you mentioned. Sometimes I
justfeellikepickingthelowhanging fruit, taking the
premiums on far out-of-themoneyoptionsthathavelittle
chance of ever being worth
something at expiration, like
selling
out-of-the-money
Calls on NetFlix when the
price was falling, Implied
Volatilitywashigh,andthere
wasnosupportinsight.”
“Low-hanging fruit,”
saidJack,ashetookasipof
hiscoffee.“Iguessafterallof
the work you put into your
other trading methods, you
deservesomeeasypickings.”
Terrylaughed.“Ialso
useasmallpercentageofmy
account
to
speculate.
Sometimestherearestocksor
sectorsthatareinthenewsso
much that it is difficult to
ignore them. Even though
these stocks are not on my
watch list, I sometimes do a
little bit of research on one
and then open an option
position to capture what the
market consensus seems to
indicate.ButIneverriskvery
muchonthesetradesbecause
the news reports are rarely
impartial.”
“I guess each one of
thosemethodswouldgiveme
anedge,andasyouhavesaid
before, with options being a
zero sum game, any edge,
even a small one, will
statistically result in the
method being profitable,”
saidJack.
Terry finished her
coffee and looked right into
Jack’seyes.Again,hervoice
took on a serious tone. “I’ve
reallyenjoyedthedinnerand
having someone to talk to
aboutmycareerinoptions.It
issocomfortingtoknowthat
thereareothersouttherethat
thinkthesamewaythatIdo.
Some traders that I talk to
lose interest, but you are the
first person I have met that
seems sincerely interested.
Youhavelearnedsoquickly,
I’m not sure if there is
anythingelseIcanteachyou.
All you need to do to profit
fromoptionsishaveanedge.
You pick the method that
suits you best, you make the
rules, and you choose the
edge that you believe will
help you the most. That’s all
thereistoit.”
“My method, my
rules,myedge,”Jackthought
to himself. As the waiter
began clearing the dessert
dishes from the table, they
both relaxed and got
comfortable in each other’s
presence.
“My goal is to trade
optionslikeyou,foraliving,”
Jacksaid.
“It is a worthy goal,
nodoubt.Ittakesmanyhours
of study to really understand
theflowofthemarkets,even
more hours of live trading
and losing to get the
experience needed to be able
to pull the trigger on live
trades. Are you ready to pay
thatprice?”Terryasked.
“Iam,andIthinkyou
have taken me to a level of
understanding where I can
begin to trade options for
profits. I also have your
notes!”Jacksaidconfidently.
“So what are your
plans for the next week of
your
vacation?”
Terry
inquired.
“Iamnotsure.Iknow
whatIwantthemtobe,andI
do have options,” Jack said,
flirting and smiling while he
lookedintohereyes.
“Show me your
options,”Terryreplied.
“I would like to have
the option of spending the
next week with you,” Jack
replied.
AppendixA
RELATIVE
TIMEVALUE
OFOPTIONS
BASEDON
THETIMETO
EXPIRATION
OFTHE
CONTRACT
The following tables
show the time value of
options relative to a contract
of exactly one year. The
column,RelativeTimeValue,
shows the time value of an
option as a multiple of the
premium on a one year
contract. A Relative Time
Value of 0.799 means that
contracts expiring in the
specified number of days
would have a premium
approximately0.799timesas
muchasacontractexpiringin
one year. The column,
Estimated Premium, shows
theapproximatetimevalueas
a percentage of the
annualizedImpliedVolatility.
An Estimated Premium of
40.0% means that options
expiring in the specified
number of days would likely
have a premium equal to
about 40.0% of the Implied
Volatility of the underlying
shares.
The tables are based
onat-the-moneyoptionsonly,
and the values presented are
by no means set in stone.
They are offered only as a
cursory guide to option
premiums,
based
upon
extensive trading experience.
Option traders may find the
followingexamplesoftheuse
ofthesetableshelpful:
Example 1: A trader
buys an option contract
exactly 365 days before its
expiration date. He wants to
know how extensively time
decaywillaffectthevalueof
his contract over the next
seven days. Looking at the
table, he sees that the
Relative Time Value after
sevendays,with358Daysto
Expiration, is 0.990. So he
shouldexpectthevalueofhis
contract to have 99.0% of its
original value after seven
days, so long as the
underlying price remains
unchanged and there are no
changes in volatility or riskfreeinterestrates.
Example 2: A trader
wantstobuyaProtectivePut,
28daysbeforeexpirationand
offset the cost of the Put by
selling a Call option, seven
days before expiration.
LookingattheRelativeTime
Value of options 28 days
beforeexpiration,heseesthat
they should cost about 0.277
times the premium of a one
year contract, while the
options expiring in seven
days are worth 0.138 times
theoneyearpremium.Hecan
then estimate that the
premium he receives on the
Short Call will be about half
of the premium he pays for
theLongPut.
Example 3: A trader
wantstobuyaCalloptionon
a stock that is currently
trading at $100.00, with an
Implied Volatility of 30%,
and 127 days until the
contract expires. Looking at
the table, he determines that
the Estimated Premium with
127 Days to Expiration is
23.59%
of
annualized
ImpliedVolatility.Giventhat
the current Implied Volatility
is30%of$100.00,or$30.00,
he can estimate that the
premiumforanat-the-money
Call option would be about
23.59% of $30.00. His
calculations lead him to an
estimated premium of $7.08.
Having found that to be very
close to the ask price in an
option table, he may feel
more confident that he is
payingafairprice.
Example 4: A trader
ownsastockthatistradingat
$100andhasseensignificant
gains, and he wants to delay
realizingthosegainsuntilthe
following tax year. Looking
at the at-the-money Put
options with an expiration
date 365 days away, he
notices that there is very low
trading volume on those
options, and the bid-ask
spread is over $1.50. So he
considers buying options that
expirein183daysandrolling
them out another 183 days
whentheyexpire.Lookingat
thetable,heseesthatoptions
with 183 Days to Expiration
cost0.708timesthepremium
of those with a one year
expiration. Realizing that he
would need to purchase two
sets of options, each lasting
183 days, to protect his
investment for a full year, he
calculates the total cost to be
1.416 times the cost of a
single one-year contract.
Looking at the option tables
forthe183dayexpiration,he
seesthatthecosttopurchase
those options, twice, would
be greater than the loss he
would experience due to the
bid-ask spread on a single
contract with a one-year
expiration.
Example 5: A trader
wants to buy Call options a
week before expiration and
sell them a day before
expiration if they are not inthe-money.Hewantstoknow
how much capital he could
save by selling early. He
looks up the Relative Time
Valueforboth,andfindsitto
be 0.138 with seven days to
expiration, and 0.052 with
one day to expiration. His
calculations reveal that a
weekly at-the-money option
would likely lose about 37%
of its time value on the final
dayoftrading.Thisleadshim
toconcludethathecouldsave
significantamountsofcapital
by closing his losing option
tradesearly.
RelativeTimeValueis
shownasamultipleofthe
premiumofa1yearcontract.
EstimatedPremiumsarea
percentageofannualized
ImpliedVolatility.
Allvaluesareforat-themoneyoptions.
AppendixB
ODDSAND
EXPECTED
PAYOUTOF
SELECTED
OPTION
STRATEGIES
The
following
analysisdepictsthestatistical
profit and loss potential of
option strategies. Each is
presentedasa‘lotteryticket.’
Rather than present the
possible profit and loss of
each strategy, the probable
profit and loss is shown. For
example, the profit potential
of a Long at-the-money Call
is very high at two standard
deviations,buttheoddsofthe
underlyingreachingthatprice
are low. The profit potential
is multiplied by the odds of
that profit being realized,
which then determines the
values plotted in the graph.
For clarity, a traditional
‘possibleprofitandloss’plot
has been superimposed over
eachgraph.
Itshouldbenotedthat
each graph is only an
approximation. Values were
determined using a modified
form of a log normal
distribution. The distribution
is based upon historical data,
andwhileitisnotguaranteed
to be accurate for any
particular stock, it is
nevertheless useful as a
guide.
The odds of winning
are presented as profit and
loss potential based upon the
initial credit or debit to open
the trade. For example, a
trade consisting of 10 Long
at-the-money Calls at $2.50
per share ($2,500 debit)
wouldhavea5%chanceofa
200% profit, or $5,000.
However, the odds shown
only apply to that specific
amount of profit. Because
there are potential profits in
excessof200%,theoddsofa
profit of at least $5,000 are
actuallyabout20%.
Note also that the
graphs and odds were
determined
with
the
assumption that the range of
-3 to +3 standard deviations
did not include negative
values for the underlying
price.Onvolatilestocks,this
assumption may be invalid.
Because the price of a stock
can never go below zero, the
weighted distribution would
be skewed; hence the odds
presented here would not be
accurate. Nevertheless, as a
general rule, these ‘lottery
tickets’ show the predicted
behavior of each strategy at
expiration.
Lastly, these graphs
may provide one additional
bit of insight into options.
The sections shaded green
represent profits, the sections
shaded red represent losses,
and the areas are nearly
equal. Over the long term,
given a sufficient number of
trades, every strategy has an
equal probability of profit or
loss.
AppendixC
THE
RELATIONSHIP
BETWEEN
OPTION
PREMIUMS,
DELTAS,
STANDARD
DEVIATIONS,
ANDPROFIT
PROBABILITIES
The probability of an
option expiring in-the-money
can generally be determined
by the Delta on that option;
e.g.aCalloptionwithaDelta
of 0.5 can be roughly
estimated to have a 50%
chance of expiring in-themoney.
However,
just
becausealongoptionexpires
with Intrinsic Value does not
mean it will result in a profit
fortheoptionbuyer;Intrinsic
Value does not always
outweighvaluelosttoTheta.
The following chart
shows
not
only
the
probability of an option
expiringwithIntrinsicValue,
but also the probability of a
buyerofthatoptionrealizing
a profit and a seller a loss.
For added clarity, the
relationship between the
StandardDeviationandDelta
arealsoshownforeachstrike
price.
It might not be
intuitively obvious to the
casual observer that it is
possible for option buyers to
have similar odds to option
sellers. In general, more
options expire with a loss in
value than in a gain, and a
significant percentage of
options
expire
totally
worthless. However, the
perception of sellers making
greater profits than buyers
may be rooted in the actions
ofthemarketmakers.
Market makers, many
of whom are engaged in the
option selling business, often
hedge their short positions.
Market makers provide
liquidityintheoptionmarket;
however they do not
necessarily profit by selling
options that expire worthless
or with less Intrinsic Value
than their original premium.
Rather, market makers profit
from the difference in the
bid/ask spread; they sell
optionsatthehigheraskprice
andbuythematthelowerbid
price. As a result there is a
common perception among
option traders that option
sellers, of which a sizeable
number are market makers,
make money while option
buyerslosemoney.
Noteonthefollowing
table that every option has a
50% or lower statistical
probability of expiring with
Intrinsic Value that exceeds
the original premium. It can
then be inferred that a buyer
ofanoption,anyoption,Call
or Put, will always have less
thana50%chanceofmaking
a profit on a single trade.
Likewise,asellerwillalways
havebetterthan50%oddsof
realizing a gain. While it is
true that option buyers have
losingtradesmoreoftenthan
sellers, over the long term,
buyers make more profits on
theirwinningtrades.Inshort,
buyers win more, less often;
sellers win less, more often.
The chart that follows shows
how the odds are stacked
againstthebuyer;however,it
also shows the manner in
which the potential profit to
thebuyerbalancestheriskof
loss.
The chart has been
simplifiedbydisregardingthe
effects of interest rates,
liquidity, kurtosis, skew, and
also the volatility smirk that
may sometimes occur. It is
presented as an aid to
understanding
option
probabilities and is not
intended to represent exact
pricing for all possible
options.
The following is an
example of how the chart
maybeapplied:
Example 1: A
trader
is
seeking
informationon
the
probabilitiesof
an out-of-themoney Call
option.
Looking at the
option chain
foraparticular
stock,henotes
that
at-themoney Calls
have
a
premium of
$10.00
per
share and the
Call option he
is considering
trading has a
premium of
$2.50.
Looking at the
chart,
all
option
premiums are
referenced to
an
at-themoney option
costing $1.00.
To use this
chart
effectively, he
will need to
multiply all
premiumsbya
factor of 10.
Call options
with
a
premium of
$0.25 on the
chart would
then have the
required $2.50
premium.
Following the
columns on
the chart, it
can then be
determined
that the Call
option with a
$2.50
premiumhasa
strike that is
located
at
approximately
1.0 Standard
Deviations.
Delta on the
option would
likely be very
near 0.2; and
he
could
estimate the
odds of the
Call expiring
in-the-money
to be 16%.
Continuing
across
the
chart, he can
estimate that
there are 14%
odds of the
IntrinsicValue
at expiration
exceeding the
original
premium; in
other words, a
14%chanceof
exceeding the
break-even
point. Given
those
odds,
over the long
term, it could
be expected
that
the
average
IntrinsicValue
present in that
specific option
on the rare
occasions
when it did
expire in-themoney would
be $15.60, as
shown in the
leftmost
column.
Statistically,
given
a
sufficiently
large number
of trades, such
as 1,000, there
would
be
$2,500
per
share in total
premiums
paid; 84%, or
840 of the
trades would
expire
worthless and
16%,or160of
those trades
would expire
with
an
average
of
$15.60
in
intrinsic value
each,
or
$2,496 in total
gains.
Statistically,
it’s a total
wash.
It
may
appear
confusing that some strikes
havehigherProbableIntrinsic
Valuesthanotherswhenthey
expire
in-the-money.
However, the differences are
not caused by one option
being more profitable than
another over the long term;
ratherthisoccursbecauseitis
profitable at a different
frequency. A far out-of-themoney Long Call might only
be profitable in one out of
100trades,wherealargegain
erasestheprevious99losses.
Itsaveragegainislarge,butit
isarareoccurrence.Deepinthe-money options expire
with Intrinsic Value nearly
100%
of
the
time;
statistically, half of the time
they will gain value and half
of the time they will lose, so
the Probable Intrinsic Value
at expiration is nearly equal
to the premium when the
tradewasopened.
On a final note, the
values shown below were
calculated using a slightly
different method from that
used in Appendix B. As a
result, there are slight
discrepancies
in
the
probabilities obtained. Those
readers intent on reproducing
the
results
of
these
probability estimates should
consider that the following
table was formulated using a
standard normal distribution
applied to current option
premiums for open option
contracts on an ETF that
tracks the S&P 500 index,
whereas the probabilities in
AppendixBusedcalculations
involving a modified log
normal distribution and longtermhistoricalpricing.
One might observe
that the statistical probability
of a Long at-the-money Call
returning a profit was
determined to be 34% in
AppendixBand35%herein
Appendix C. Again, option
pricing is an art, and it is
ultimatelythedecisionofthe
trader to choose which type
of statistical model fits his
needs or whether a few
percentagepointsonewayor
theotherwillhaveanyeffect
onhistrading.
As in Appendix B,
StandardDeviationsshownin
this table are time-weighted.
One Standard Deviation
referstotheprobabilityofthe
underlying price reaching a
specific strike price upon
expiration of the contract. It
should not be confused with
the annualized Standard
Deviation of the underlying
share price, which is often
stated as annualized Implied
Volatility. The only option
contracts for which Implied
Volatility represents exactly
one Standard Deviation are
thosewhichexpireinexactly
one year. A conversion table
for option contracts expiring
in less than one year may be
foundinAppendixA.
AppendixD
TIME
PROGRESSION
PAYOUT
POTENTIAL
The following graphs
show the differences in
possible profit and loss on
selectedoptionstrategiesasa
function of time. For each
strategy,itisassumedthatthe
tradeisopened30daysprior
to expiration. Profits and
losses are then plotted based
uponanimmediatechangein
the underlying price, with 30
days
remaining
until
expiration. Additional plots
show the possible profit or
loss with seven days to
expiration,andalsoattheend
ofexpirationday.
There are several
characteristics that should
become apparent from a
studyoftheseplots.First,the
profits and losses are most
sensitive to time when the
underlying price is near zero
Standard Deviations. As the
priceapproachesoneextreme
or the other, the performance
ofeachoptionstrategyisless
dependent on the time
remaining to expiration.
Theseeffectsaretheresultof
a combination of Theta and
Moneyness. When options
are near-the-money, Theta
has its most pronounced
effect; time value slowly
decreases,loweringthevalue
of each option as time
progresses. When options
becomedeepin-the-moneyor
far out-of-the-money, the
change
in
Moneyness
decreasesthetimevalue.
Second, most option
strategieshaveprofitandloss
potentials which gradually
approachtheshapeoftheplot
as it would appear on
expirationday.Astimedecay
accelerates, a single option
willloseabouthalfofitstime
value during the first three
weeks of a 30-day contract,
andtheremaininghalfwillbe
lostinthefinalweekleading
up to expiration. However,
not all strategies are affected
equally by time, namely
Spreads. A Vertical Spread
tendstolosemuchlessofits
combined time value during
thefirstthreeweeks,perhaps
only
one-third,
then
accelerates more quickly,
losing the remaining twothirds during the final seven
days of trading. With
Butterflies and Condors, the
effect is even more
pronounced;
without
significant change in the
underlying price, these
strategies
may
only
experience a combined loss
of time value of one-tenth in
thefirstthreeweeks,withthe
remaining90%oftimedecay
occurringinjustsevendays.
Third, the most
strikingexceptiontothetime
decay characteristics are the
SyntheticLongandSynthetic
Short Stock, both of which
areunaffectedbytime.
AppendixE
EXPANDED
TABLEOF
SYNTHETIC
POSITIONS
Due to the possibility
ofoptionlossesexceedingthe
total value of a trader’s
account, most brokers limit
theoptionstrategiesavailable
to
individual
traders.
However,manystrategiescan
be created synthetically to
yield similar performance to
thetraderwithoutaddingrisk
tothebroker.
One of the simplest
examples of a position that
might be prohibited by a
brokerwouldbeaNakedPut.
A trader seeking the
performance of a Naked Put
will experience similar profit
and loss by opening a
Covered Call at the same
strike price that would have
been used in a Naked Put
position.Thepotentialprofits
are not exactly the same for
bothpositionsduetotheloss
of potential gains on the
capital required to open the
Covered Call (either through
interestincomeorgainsfrom
other
potential
trades);
however, the option trades
themselves
are
nearly
identical.
The following table
shows
the
synthetic
equivalent for some of the
more
common
option
strategies. It should be noted
that some of the synthetic
positions are not exact
equivalents;thosethatrequire
theuseofdeepin-the-money
options
are
merely
approximations.Forexample,
aSyntheticLongpositioncan
be approximated with a deep
in-the-money Long Call.
Such an option would have
little or no time value
remaining
and
would
therefore behave nearly
identically to an equivalent
long position in the
underlying shares. However
in practice, the option would
likelyhaveverylowliquidity.
Even if it was possible to
trade the option, the bid/ask
spread could be significant.
Even so, there are often
options
available
with
sufficient liquidity and
Moneyness
that
their
relatively small time value
makes them a viable
alternativetoSyntheticStock
positions.
AboutSteve
Burns
Steve Burns has
been an active trader
for over 12 years. He
istheauthorof"HowI
Made Money Using
the Nicolas Darvas
System," published by
BN
Publishing
(available at all major
Internet retailers). He
ranksinthetop300of
all reviewers on
Amazon.com. He is
also one of the site's
top reviewers for
books about trading.
He has been featured
as a top Darvas
System trader on
DarvasTrader.com and
interviewed on the
Miss Trade YouTube
channel. He has also
been a contributor to
ZenTrader.ca
and
Business Insider. He
livesinNashville,TN,
with
his
wife,
Marianne, and their
five children: Nicole,
Michael, Janna, Kelli,
Joseph. He has one
granddaughter,Alyssa.
Steve Burns has
not had a losing year
actively trading in his
main two accounts
since 2002. From
2003-2007hereturned
anaverageannualgain
of22.95%andwentto
a cash position on
January 4th, 2008,
keeping all of his bull
marketreturnsthrough
the Great Financial
Panic.Histradingbeat
the S&P 500 for six
straight years and had
a cumulative 209.5%
return over an eightyear period. His
returns doubled the
market
returns,
averaging
15.7%
versus
the
S&P
returning 7.8% from
2003-2010.
Theauthortrades
accounts worth over a
quarter of a million
dollars.
ConnectwithSteve:
E-Mail:
[email protected]
WebSite/Blog:
www.NewTrader
FacebookPage:
https://www.faceb
Twitter:
@SJosephBurns
About
Christopher
Ebert
Christopher
Ebert has been a real
estateinvestorforover
24 years and an active
stock and options
trader for over 14
years. His formal
education
includes
undergraduate studies
in engineering at the
State University of
New York and at
Rochester Institute of
Technology.
His
option research is
featured regularly on
Zentrader.ca where he
is a contributor. He
lives in Rochester,
New York, with his
wife Anita and their
daughterBreeanna.
Christopher
Ebert is a contrarian
trader and as a result
was able to sidestep
the majority of the
downside of the Bear
Market of 2002 and
Great Financial Panic
of 2008. He has
outpaced the S&P in
13ofthepast14years.
Having gone to all
cash during the final
runoftheBullMarket
during the spring of
2008, and then gone
all-in on February 11,
2009, he missed the
market bottom by less
than 30 days, leading
to a gain of over 50%
for the year. His real
estate holdings, also
being contrarian in
nature, were mostly
unaffected by the U.S.
Housing Bubble and
the
crisis
that
followed.
Theauthortrades
accounts worth over a
quarter of a million
dollars.
Connect
Christopher:
with
E-Mail:
[email protected]
Twitter:
ChristopherEbert@
Contributorto:
Zentrader.ca
References:
www.Dictionary.com
(Used with
permission)
http://www.optiontradingpedia.com/optio
*Quote from chapter 16 by
professional trader Jack
Mega.
Wehaveabook
recomendation
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NewTrader,RichTrader:HowtoMake
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StockOptions:TheGreatestWealth
BuildingToolEverInvented
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62RulesUsedByForex,Futuresand
StockMarketsTraders
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HowIMadeMoneyUsingtheNicolas
DarvasSystem,WhichMadeHim
$2,000,000intheStockMarket
BySteveBurns
TheRichestManinBabylon:Now
RevisedandUpdatedforthe21st
Century
ByGeorgeS.Clason
TheMasterKeytoWealth
byDr.JosephMurphy
YouCanStillMakeItInTheMarket
byNicolasDarvas
RulesUsedbyProfitableTradersfor
InvestinginGoldandSilver
ByArikZahb
Availableat
www.bnpublishing.net